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DARP Paper
Hierarchic contracting
Rafael Hortala-Vallve and Miguel Sanchez
September 2005
Paper No' DARP 073:
Full Paper (pdf)

JEL Classification: D80; J30; L22; M12

Tags: principal-multi-agent relationships; moral hazard; team production; decentralisation; hierarchies; contract design

We analyze the contracting structure in a moral hazard setting with several agents where output is produced jointly and is the only contractible variable. Since the salary of each agent is a function of all agents efforts, a positive externality arises between them. This externality is not internalised by a centralised structure where the principal contracts directly with each agent. Instead, we find that a hierarchic structure (i.e. the delegation of 'contracting rights' from the principal to the agents) internalises the externality by making agents 'residual claimants'. Consequently, the second best situation can be improved upon just by changing the contracting structure of the principal-agents relationship. The analysis is relevant to the literature on decentralisation, outsourcing, subcontracting and intra-firm organization.