Organizational Design with Non-Contractible Quality
When contracting with an agent who is a worker of non-contractible quality, a principal considers mechanisms with an informed third party, a manager. To induce the manager with limited liability to report worker quality truthfully, the principal devises the first-order alignment, an incentive alignment based on the first-order condition with an interval structure. We show that the mechanism of contracting simultaneously with the manager and the agent dominates the optimal “selling the project” mechanism at a low information cost. The interplay between information cost and limited liability results in three optimal organizational structures: simultaneous contracting (manager inside the firm), ex ante contracting (out-sourcing), or partial contracting (no manager). Lastly, we apply this model to explain what may cause the difference in the firm structure across three types of labor market