Inter-Divisional Contracts

Franz Wirl

International Journal of the Economics of Business, 2004, vol. 11, issue 2, 197-216

Abstract: This article considers distributed and hierarchical decisions where the actions of two units of a firm (divisions, brands, departments) lead to externalities. For example, brand 1 plans to offer a new product that could have adverse effects on products from brand 2. Each unit has private information concerning the benefit ('1') and the harm ('2'). The second unit may ask the executives to intervene by either quantitative or financial interventions. The executives lack the private information and thus impose either a penalty or a standard, probably based on some average values. The surprising feature is that the resulting contracts (offered by '2') deviate substantially from the conventional contracts. First, considering standards, countervailing incentives - 'no distortion' at both ends - are optimal. A penalty leads to even more complex arrangements covering four different kinds of contracts including 'no distortion at the top', 'no distortion at the bottom', 'no distortion at an interior point', and a boundary solution (duplicating the executive's intervention). A comparison reveals that the standard outperforms the penalty.

Keywords: Intra-Firm Contracts; Externalities; Organizational Instruments (search for similar items in EconPapers)
Date: 2004
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DOI: 10.1080/1357151042000222828

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