Contracting and Organization Design Under Joint, Sequential Production

Nearly all organizations of any type, size or scale produce their final output via aprocess characterized in some form by (i) joint contributions from multiple individualagents and (ii) a sequential work flow in which “upstream” agents take actions that mayimpact the choices made by those “downstream,” at later stages. However, in modelsof core organizational design decisions such as compensation, hiring and training, theeconomics and management literatures have typically focused on atomistic agents. Ina general model of joint, sequential production with an arbitrary number of agents,we demonstrate that the relative power of compensation schemes from stage to stagedepends on the nature of the production technology. When the technology is super modular, such that effort choices are increasing in productivity, the power of schemeswill increase monotonically as one moves from the beginning to the end. The resultis driven by the fact that, in such interdependent processes, agents do not accountfor the impact of their choices on the effort costs of those downstream from them.Thus, incentives must be attenuated to prevent supra-optimal effort. The oppositeis true – the power of schemes decreases from stage to stage – when the technologyis submodular. At a general level, our findings highlight the importance of factorsother than risk aversion – in particular, process design and production technology –in determining and explaining compensation schemes. We also demonstrate the im plications for a broader set of organizational design issues such as the allocation oftraining investment and intra-organizational preference for risk tolerance