Organizational Form, the Business Environment, and Competitive

Strategy

David Gaddis Ross

Columbia Business Schooly

September 2007

Abstract

This paper uses a principal-agent model to investigate how the business environment af-
fects the decision to delegate or centralize project selection authority. Delegation is optimal
when the level of competition is low, economic conditions are moderately, but not extremely,
favorable, and good and bad projects are relatively dissimilar. Delegating …rms also compete
more aggressively, suggesting a link between strategy and structure. Finally, there is an inverse
U-shaped relationship between the number of competitors for a project and the value realized
by the project’s sponsor, implying that competition among counterparties in the "value net"
does not always bene…t the focal enterprise.

1 Introduction

Two long-standing and related questions in management research are how to tailor a …rm’s or-

ganizational form (a) to its strategy, which dates at least from Chandler (1962), and (b) to the

environment, which dates at least from Lawrence and Lorsch (1967). In turn, a key issue in organi-

zational design is whether to use an incentive contract to induce employees to make good decisions

on the organization’s behalf or whether to rely on a costly monitoring technology to make decisions

centrally. Although the formal analysis of the choice between delegation and centralization is the
I am grateful for helpful comments to John Asker, Heski Bar-Isaac, Kose John, Alexander Ljungqvist, Anthony
Saunders, and Bernard Yeung. Errors and omissions are the author’s sole responsibility.
y
Columbia Business School, Uris Hall, New York, NY 10027; dr2175@columbia.edu.

1
subject of a vast literature, the e¤ects of competitive strategy and the environment on this choice

have been largely unexplored. This paper …lls this gap by providing a formal analysis of how the

choice of whether to delegate or centralize decision-making authority is a¤ected by the business

environment, and how, in reciprocal fashion, organizational form is linked to a …rm’s competitive

strategy and a¤ects other parties in a …rm’s "value net" (Brandenburger and Nalebu¤, 1996). The

results also shed light on which combinations of …rm strategy and organizational form are likely to

result in better …rm performance, given prevailing economic and competitive conditions.

Managerial decisions come in many forms. Empirical evidence suggests that the question of

whether to delegate authority over "very routine tasks" is not related to …rm strategy (Miller 1988:

303) and thus may be more a matter of day-to-day operational e¢ ciency. It is therefore important

to focus on "big" managerial decisions that may impact a …rm’s competitive trajectory. Among the

biggest decisions are those that relate to project choice, which inevitably involves capital budgeting

and the investment of …rm capital (Holmström and Ricart i Costa, 1986). A project could be a new

plant, a potential acquisition, or, more generally, the procurement of a "strategic factor," which can

alter a …rm’s competitiveness at a stroke (Barney, 1986). In some industries, moreover, investment

of …rm capital is a core activity, as in banking through the loan-making function. Credit evaluation

is in many ways a capital budgeting process (Sharon, 1983).

This paper considers a model where a …rm run by a risk-neutral principal hires a risk-neutral

agent with limited liability for the purpose of evaluating a project that, if undertaken, requires

the investment of …rm capital. There is also a risk-neutral counterparty to the transaction whom

we will label the project’s "sponsor" and which could be a seller, investee, or borrower, depending

on the context. The principal may, at a cost, implement a monitoring technology that veri…es

the attributes of the project; such a technology could be the principal’s own costly evaluation

e¤orts, a corporate planning team, or (in a banking context) a credit control department. Call this

centralization. Alternatively, the principal may rely on an incentive contract to induce the agent

to make an appropriate decision on the principal’s behalf. Call this delegation. Under delegation,

the principal does not bear the cost of monitoring. At the same time, the principal cannot verify

the agent’s evaluation e¤orts, giving rise to a moral hazard problem.

Since the agent’s e¤ort is not subject to moral hazard under centralization, the principal may pay

the agent a ‡at wage. Under delegation, in contrast, the agent must be o¤ered a lottery consisting

2
of a high payment (reward) for a successful project, a low payment (penalty) for an unsuccessful

project, and a reservation wage for rejecting the project. The spread in wage outcomes is restricted

by the agent’s limited liability, making wages for delegation higher than for centralization. Whether

delegation or centralization is pro…t-maximizing is therefore a question of whether the higher cost

of incentivizing the agent with the former is o¤set by the cost of the monitoring technology with

the latter.

An important aspect of delegation is that the agent must be given incentives not to accept or

reject a project "blindly," i.e., without having expended costly e¤ort to gather information about it.

When the probability is high that a randomly-selected project is "good,", i.e., has a positive NPV,

inducing the agent not to accept blindly requires a relatively large spread in wage outcomes. When

the probability is high that the agent will exert costly e¤ort yet have to settle for the reservation

wage, inducing the agent not to reject blindly also requires a large spread in wage outcomes. In

either case, delegation is relatively costly vis-à-vis centralization. In similar fashion, the "…ner the

distinction" between good and bad projects, i.e., the more similar they are, the more high-powered

must be the agent’s incentives under delegation and thus the greater is delegation’s relative cost.

These general results have a number of more speci…c implications.

To wit, suppose the principal wishes to evaluate a project where the amount to be invested

is uncertain either because the reservation price of the sponsor is unknown to the principal or

because there may be other …rms competing for the project who might outbid the focal …rm. Call

the …rst case "limited monopoly" and the second "competition." In either case, the lower the price

the focal principal o¤ers the sponsor, the higher is the probability that the sponsor will reject the

o¤er, and thus the more often that the principal’s agent under delegation will have to settle for

the reservation wage. The relative cost of delegation is accordingly decreasing in the principal’s

o¤er, implying that delegating …rms compete more aggressively (i.e., o¤er sponsors higher prices)

than centralizing …rms. Thus, (a) aggressive competition and delegation and (b) accommodating

competition and centralization are both ideal "strategy con…gurations" (Miller, 1986), whereas the

other combinations are not. For similar reasons, as the probability of being outbid increases with

the number of …rms competing for the project, so too does the relative cost of delegation, prompting

an increase in the proportion of …rms that centralize. We thus have a clear prediction that the

incidence of centralization increases with the level of competition.

3
 Another interesting feature is that competition simultaneously reduces …rms’ability to extract

sponsor surplus and increases the risk that the focal …rm’s evaluation costs will be wasted because

the …rm is outbid by a competitor. The …rst e¤ect is dominant for low levels of competition, and

the second e¤ect for high levels. In consequence, there is an inverse U-shaped relationship between

the number of competing …rms and the price o¤ered sponsors such that the level of competition

that maximizes sponsor pro…ts is precisely the level where the competing …rms make zero pro…t in

expectation. As the level of competition moves beyond that point, the average price received by the

sponsor declines. This has implications for the optimal number of relationships a …rm should retain

in its "value net" and suggests that the classic view that more competition among counterparties

is bene…cial for the focal enterprise may not always obtain (e.g., Porter, 1979).

Now, consider economic conditions. It is natural to assume that the proportion of good projects

would be lower in recession and higher when the economy is booming.1 In this model, when

economic conditions are particularly good, it is relatively expensive to induce an agent under

delegation not to accept blindly; and, in corresponding fashion, when economic conditions are

particularly bad, it is relatively expensive to induce the agent not to reject blindly. The implication

is that centralization is optimal at peaks and valleys of the economic cycle, with delegation being

optimal at intermediate stages.

Finally, on a more abstract level, the "meaningfulness" of the distinction between good and

bad projects is likely to vary among business environments. We can think of a good project as an

opportunity to move to a higher peak on a business landscape à la Levinthal (1997), whereas a bad

project represents a "false step" into a trough. Now, the greater is the distance from trough to

peak, the …ner is the distinction between them. In other words, the more similar are the good and

bad projects, the more high-powered must be the agent’s incentives under delegation, and thus the

higher is delegation’s relative cost. In this way, we can map features of the "topography" of the

business landscape to a …rm’s organizational form.

The work herein is also related to several strands of literature in formal economic theory. The

interaction between organizational form and project choice has been considered by Stein (2002),

who studies how the level of information "hardness" in the environment a¤ects whether stand-
1
In the banking literature, for instance, authors have assumed that the proportion of creditworthy borrowers in
the economy is positively related to the business cycle [e.g., Ruckes (2004)].

4
alone …rms do better than a single integrated holding company in allocating capital to competing

projects. Here, the model considers a single project, and the question is how best to assess it.

In a paper from the literature on the interaction between managerial incentives and competition,

Hermalin (1994) shows that, in a market share game, the best response to another …rm providing

strong incentives may be to provide weak incentives; this may lead otherwise identical …rms to

adopt heterogenous compensation schemes. In a similar setting, Vroom (2006) …nds that it may

be optimal for one …rm to decentralize and use incentives to behave aggressively, while the other

…rm does the opposite. We also …nd that ex ante identical …rms may adopt heterogenous strategies

and organizational forms, but the result is driven by how competition a¤ects the relative cost of

delegation and centralization. This paper considers project choice in the face of managerial moral

hazard. This general setting has been considered by Lambert (1986), who focuses on the trade-o¤

between motivating the agent to work hard and motivating the agent to make a good investment

decision, and Ross (2007), who treats project choice in a multitasking context.

The model herein posits a competitive framework where …rms assume a cost for the right

to make o¤ers against an unknown number of competitors. Related work includes Janssen and

Rasmusen (2002), which treats Bertrand competition with an unknown number of competitors and

no cost to compete, and Sharkey and Sibley (1993), which analyzes Bertrand competition with a

known number of competitors and a …xed cost to compete. Unlike the present work, neither of

those papers considers how competition a¤ects organizational form. In addition, in Janssen and

Rasmusen (2002), the expected winning o¤er monotonically deteriorates from the perspective of

the …rm making the o¤er (i.e., the price charged declines) as the number of competitors increases,

and in Sharkey and Sibley (1993), the expected winning o¤er monotonically improves; here, there is

a non-monotonic relationship between the expected winning o¤er and the number of competitors.

The remainder of the paper is organized as follows. Section 2 develops a principal-agent model of

project choice where the principal of a …rm with monopoly power is uncertain about the reservation

price of the project’s sponsor. Section 3 studies competitive interaction in the absence of monopoly

power. Section 4 examines how changes in economic conditions interact with the decision to delegate

or centralize. Section 5 considers variation in the similarity of good and bad projects. Section 6

discusses empirical implications and concludes. The Appendix contains proofs and formal analysis

not provided in the text.

5
2 Limited Monopoly

Consider a risk-neutral principal who seeks to maximize the pro…ts of an entity that has a project

that, if undertaken, requires the investment of …rm capital. We will call this entity the "…rm." The

principal can be regarded as the …rm’s owner whose investment portfolio is su¢ ciently diversi…ed

that the principal is risk-neutral with respect to the …rm’s pro…ts. There is a risk-neutral coun-

terparty to the investment transaction, whom we will dub the "sponsor." The sponsor could be

the seller of an asset, an investee, or a borrower, depending on the context. One period later, the

project yields a positive return R if it "succeeds," which occurs with probability 1 d; otherwise,

the project "fails," yielding 0. With probability , d = d, and with probability 1 , d = d, where

0 < d < d < 1. Let I be the minimum price the sponsor will accept. I is known only to the sponsor,

but it is common knowledge that, across the population of sponsors, I H (I) on 0 < I; I . It is

also assumed that d is su¢ ciently high and R su¢ ciently low that accepting the project "blindly,"

i.e., without determining d, is a loss-making strategy.2

To gather information about the project, the principal must retain the services of an agent, who

can be regarded as the …rm’s manager. The agent is risk neutral, seeking to maximize a utility

function of the form w e, where w is wages received and e is a cost of e¤ort. The agent has a

limited liability constraint such that w 0.

In the …rst stage of the game, the principal o¤ers the agent a compensation contract, which

includes details of the o¤er to be made to the sponsor. The wage payments can vary according to

the future state of the world in the principal’s information set. For example, the payment made

when a project is "accepted" and succeeds may di¤er from that when a project is "rejected" or

is accepted but fails. Payments are enforceable, i.e., the principal cannot renege. At the time of

contracting, the principal also decides whether to delegate or centralize. Under delegation, the

principal gives the agent incentives in the employment contract that ensure the agent will make

a good decision about the project. Under centralization, the principal makes an investment M

in a monitoring technology, which allows the principal to evaluate the information that the agent

generates about the project and thereby make an informed decision without relying on the agent’s
2
If the counterparty is an investee or borrower, R
I
would be the maximum interest rate the counterparty would
accept. In a banking context, one might assume that I was …xed but that the borrower’s reservation interest rate R
was only known by the borrower. The model’s results are robust to this renormalization.

6
recommendation. The monitoring technology could represent the principal’s own costly evaluation

e¤orts, a central-planning department in …rm headquarters, or, in a banking context, a credit

control department or quantitative credit scoring information system.3 The model is structured

so that a …rm either centralizes or delegates but not "both." This not only conforms to stylized

typologies of organizational form but also allows us to focus more sharply on the relative cost of

the two organizational forms in di¤erent competitive and economic environments.

If the agent accepts the employment o¤er, the agent observes whether the principal is monitoring

and decides whether to exert costly e¤ort e to gather information about the project. If no e¤ort

is exerted, the agent learns nothing of the project’s quality but may still accept "blindly." If the

agent exerts the costly e¤ort, the agent learns the project’s quality, i.e., whether d = d or d = d.4

The agent then decides whether to pass the principal’s take-or-leave-it o¤er to the sponsor.5 The

probability the sponsor will accept the o¤er is exogenously given by the function q ( ), where

2 I; I is the price the principal o¤ers.6 Clearly, q (I) = 0 and q I = 1. q ( ) thus captures

the uncertainty the principal and agent have about the sponsor’s reservation price. Although the

principal sets and therefore knows q, if the project is rejected, the principal does not know whether

the agent has made an o¤er to a legitimate sponsor unless the principal has invested M and has

therefore veri…ed the project’s attributes. If the o¤er is made, the sponsor accepts or rejects the

o¤er. If the o¤er is accepted, the transaction occurs and the project then succeeds or fails. Finally,

the principal makes the agent the appropriate contractual payment.

3
It is not material whether the agent knows that the principal has expended M before the agent accepts the
employment contract. Any assumption that ensures the agent knows whether the principal is monitoring before the
agent decides whether to exert costly e¤ort will produce identical results.
4
Allowing the agent to acquire some knowledge of I as well would not qualitatively change the paper’s results. The
important point is that the agent learns something about the project that the principal can only learn by undertaking
costly monitoring. One could also posit a di¤erent e¤ort level, depending on whether the agent has authority to accept
the project or not. This is formally equivalent to changing M , so this distinction is not pursued in the text.
5
By the Revelation Principle, it would be equivalent for the principal to make the o¤er to the sponsor according
to the agent’s recommendation.
6
In principle, 2 R, but an o¤er outside the range in the text is a dominated strategy.

7
 Period Moves

t=0 - Principal o¤ers employment contract to Agent (including terms of o¤er to Spon-

sor), decides whether to monitor at cost M

- Agent accepts or rejects o¤er

t=1 - If Agent accepted o¤er, Agent decides on e¤ort level

- If no e¤ort is exerted, Agent learns nothing of d

- If Agent exerts e > 0, Agent learns d and Principal does as well if monitoring

t=2 - Agent decides whether to pass o¤er to Sponsor

- Sponsor accepts or rejects o¤er if made

t=3 - Project, if accepted, succeeds of fails

- Principal makes appropriate contractual payment to Agent

The ideal employment contracts are a function of whether the principal is monitoring or not.

We have two possibilities:

Centralization: The agent must be compensated for the costly e¤ort required to gather infor-

mation about the project; the principal, having invested M , ensures a good decision is made

on the basis of that information

Delegation: The agent must be compensated for the costly e¤ort required to gather informa-

tion about the project as well as induced to make a good decision about whether to accept

or reject the project

Under centralization, monitoring eliminates the moral hazard problem. We can therefore, with-

out loss of generality, restrict our attention to a ‡at wage contract, where the principal pays the

agent wc = e provided the agent does not shirk. The …rm’s pro…ts are then:

c = q ( ) [R (1 d) ] e M

Under delegation, the principal’s problem is more complicated, because the principal must use

8
incentives to induce the agent to undertake the desired behavior. Formally, the …rm’s pro…ts are

d = q ( ) [(R wdH ) (1 d) wdL d ] [1 q ( )] wdR

where wdH ; wdL ; wdR are respectively the reward for a successful project, penalty or low wage for a

project that fails, and the reservation wage if the project is rejected:

e
wdH =
d d (1 ) q( )
e 1 d+ d d
wdR =
d d (1 ) q( )
wdL = 0

A derivation of this contract may be found in the Appendix. We thus have:

Proposition 1 The pro…tability and wage payments for centralization and delegation under limited

monopoly are as described above.

Given that the ideal wage contract under delegation must meet a variety of incentive compati-

bility constraints, we would expect wages to be higher for delegation than for centralization. This

is easy to demonstrate algebraically.

Proposition 2 Under limited monopoly, expected wages are higher for delegation than for central-

ization.

Proof. The di¤erence in expected wages for delegation and centralization is equal to:

e e 1 d+ d d e 1 d+ d d
q (1 d) + (1 q) e= >0
d d (1 ) q d d (1 ) q d d (1 ) q

It is up to the principal to decide which of the two organizational forms yields higher pro…ts.

It should be clear that centralization is more pro…table at M = 0 and that there is an M =

e(1 d+(d d) )
> 0 where the pro…tability of delegation and centralization are equal.
(d d)(1 ) q

9
 Note that q a¤ects the …rm’s pro…ts in two ways, …rst by a¤ecting the probability that the …rm

will undertake a successful project, and second, under delegation, by a¤ecting the wage payments.

This means the relative pro…tability of the organizational forms changes systematically as q changes.

Proposition 3 Under limited monopoly, as q increases, c d declines.

Proof. c and d are identical except for the di¤erence in wages. Di¤erentiating this di¤erence in

respect of q yields:
!
d e 1 d+ d d e 1 d+ d d
= <0
dq d d (1 ) q d d (1 ) q2

Thus, as q increases, d increases by more than c.

The intuition for this result is that the wages under delegation induce optimal investment

decisions using a lottery consisting of a reward (wdH > wdR ) and a penalty (wdL < wdR ). When

the project is good (d = d), the expected utility to the agent from this lottery is higher than

the utility from the reservation wage of wdR , but the lottery with favorable odds only arises in

proportion to q. Thus, as q declines, the reward and penalty are invoked more rarely and must

accordingly become more extreme, increasing the impact of the agent’s limited liability constraint.

This has implications for the terms the …rm o¤ers the sponsor. Given any 2 I; I ; q = H ( ).

Thus, the pro…t function for the …rm under centralization can be written:

c = H ( ) [R (1 d) ] e M

The pro…t-maximizing c solves the following equation:7

H ( ) + H 0 ( ) [R (1 d) ] =0

We thus have something akin to an industrial model of monopsony. H ( ) is like a supply curve,

and R (1 d) is the marginal value product. Marginal value does not vary with q ( ); thus, the

marginal value product curve is ‡at. M and e are …xed costs absorbed by the …rm. The marginal

cost curve lies above the supply curve, because increasing increases the o¤er for all sponsors,
7
This assumes H ( ) is di¤erentiable. It would be straightforward, but not instructive, to generalize the expression
to account for mass points, gaps, and in‡ection points in H ( ).

10
 V

MC

S
MVPd

RÝ1 ? dÞ
V Dd MVPc
B
V Dc
A

0 LHÝV Dc Þ LHÝV Dd Þ L LHÝVÞ

Figure 1: O¤ers under Limited Monopoly

not just the marginal sponsor.8 The supply curve and thus the marginal cost curve may "wiggle,"

re‡ecting changes in H 0 ( ). Because of the upper bound on I, the supply curve has a kink at I,

at which point it becomes vertical. The marginal cost curve has a kink at the same "quantity" but

at a higher "price." The marginal cost curve is thus a correspondence where supply is . Clearly,

the …rm would never o¤er more than I. Therefore, c is de…ned by the intersection of the marginal

value product and cost curves at some I. The corresponding probability a project is undertaken

is H ( c ). Figure 1 provides an illustration.

8 1 S
Formally, let the S = H ( ) be the supply of projects. Then, the inverse supply curve is =H and the
0
1 S 1 S 1 S
marginal cost curve is H +H S>H .

11
 In similar fashion, the pro…t function under delegation can be written as:
" ! #
e
d = H( ) R (1 d)
d d (1 ) H( )
e 1 d+ d d
(1 H ( ))
d d (1 ) H( )
e 1 d+ d d
= H ( ) [R (1 d) ] e
d d (1 ) H( )

We see that there is a …xed component, which does not depend on , and a variable component,

which does. The pro…t-maximizing d solves the following equation:

e 1 d+ d d H0 ( )
H ( ) + H 0 ( ) [R (1 d) ] + =0
d d (1 ) H ( )2

This is identical to the corresponding …rst-order condition for centralization, except for the last term

on the right, which is positive. This means that at c, the foregoing expression is positive. But

we can say more. Proposition 2 implies that marginal costs under delegation are less than those

under centralization, because the only di¤erence between the two is the higher expected wages

under delegation, which are everywhere decreasing in . In other words, because total wages are

decreasing in q under delegation, delegation gives the principal an incentive to lower the probability

that the o¤er will be refused. We can therefore conclude that d > c. This is depicted in Figure

1.

In consequence, the sponsor is unambiguously better o¤ when the principal delegates. If the

principal centralizes, the sponsor receives (expected) surplus equal to the area over the supply

curve, under the c price line, and to the right of the vertical axis. This area is labeled A in Figure

1. If the principal delegates, the sponsor receives surplus of A + B in the …gure.9

9
These results have surprising implications for the impact of technological progress on the project’s sponsor.
Suppose that in a given market, the principal is delegating, because M = M + > M . Further suppose that a
positive technological shock occurs driving M to M , say, because of new techniques in corporate planning or
credit scoring or simply because the principal acquires better skill in monitoring the agent. The principal will shift
to centralization, earning an increase of 2 0 in pro…ts, but the sponsor loses surplus of B >> 2 . It would actually
behoove the sponsor to "bribe" the …rm not to adopt the new technology. However, if technological progress lowers
M to the point where the increased pro…tability of the …rm more than o¤sets the loss in sponsor surplus, such a
bribe is unfeasible. Of course, where delegation is not feasible - because, say, the required wages would be too high -
technological progress can open up new markets to the bene…t of sponsors.

12
3 Competition

In the previous section, uncertainty arose over the sponsor’s reservation price. Here, we focus on

uncertainty that arises from competitive interaction. Assume, then, that H ( ) has a mass of 1 at

some I and that the market in question has N + 1 …rms, each with its own principal and agent

pair. Each principal may elect to hire the corresponding agent (i.e., make the agent an acceptable

employment o¤er) to gather information about a project chosen from a set of cardinality P , where

each project has a di¤erent sponsor. Each agent chooses a project and each principal determines

what to o¤er, in each case without knowing what the other agents and principals are doing. (We

will see below that this model of competition e¤ectively subsumes the case where the principals

know for certain how many others they are competing with for a given project.)

Under limited monopoly, q ( ) was exogenous. Here, q ( ) is determined endogenously as a

result of competitive interaction. This does not change the optimal contract for centralization, but

does alter the wage payments for delegation. The reason is that under monopoly, q ( ) was only

a function of H ( ), and we assumed that H ( jd = d) = H jd = d ; 8 . In contrast, under this

model of competition, q jd = d = 1; 8 I , because, in equilibrium, only sponsors with good

projects receive o¤ers. Thus, the payo¤ to an agent from accepting blindly, i.e., without evaluating

the project, has changed.

We must accordingly modify our previous results for the wage payments under delegation. These

are derived in the Appendix:

e (1 (1 q ( )) )
wdH =
d d (1 ) q( )
e 1 d (1 ) + (1 d) q ( )
wdR =
d d (1 ) q( )
wdL = 0

We thus have:

Proposition 4 The pro…tability and wage payments for centralization and delegation under com-

petition are as described above.

As with the case of limited monopoly, expected wages are higher for delegation:

13
Proposition 5 Under competition, expected wages are higher for delegation than for centralization.

Proof. The di¤erence in expected wages for delegation and centralization is equal to:

e (1 (1 q) ) e 1 d (1 ) + (1 d) q e 1 d (1 ) + (1 d) q
q (1 d)+ (1 q) e = >0
d d (1 ) q d d (1 ) q d d (1 ) q

Again, as under limited monopoly, delegation becomes relatively more pro…table as q increases.

Proposition 6 Under competition, as q increases, c d declines.

Proof. c and d are identical except for the di¤erence in wages. Di¤erentiating this di¤erence in

respect of q yields:
!
d e 1 d (1 ) + (1 d) q e 1 d
= <0
dq d d (1 ) q d d q2

Thus, as q increases, d increases by more than c.

We are now ready to characterize the competitive interaction. The analysis is con…ned to

symmetric equilibria.

Proposition 7 Where (i) N + 1 …rms compete for the projects of P sponsors, (ii) each …rm

undertakes at most one project, (iii) principal-agent pairs are randomly matched with sponsors,

and (iv) tie o¤ ers are randomly resolved, there is a unique symmetric subgame perfect equilibrium,

where: (a) each principal hires an agent with probability 2 (0; 1]; (b) each principal who hires

an agent, centralizes with probability 2 [0; 1] and makes an o¤ er according to the function Fc ( )

and, with probability 1 , delegates and makes an o¤ er according to the function Fd ( ); (c)

F( ) = Fc ( ) + (1 ) Fd ( ) is a unique10 continuous probability distribution de…ned on an

interval I ; ; (d) the support of Fc ( ) is I ; c , and the support of Fd ( ) is I ; d if =0

or d; d where c = d if is strictly between 0 and 1; and (e) the …rms make positive pro…ts

in expectation if = 1 and zero pro…ts otherwise.

Proof. See Appendix.

10
Modulo null sets.

14
 The intuition for the equilibrium is that, as per standard Bertrand arguments, outbidding will

defeat any potential equilibrium in pure strategies, except the equilibrium where one and only

principal hires an agent and makes an o¤er at the highest price consistent with nonnegative pro…ts.

But if only one principal does so (i.e., if only one principal hires an agent), the principal of that

…rm has a pro…table deviation to = I . At the same time, a …rm whose principal hires an agent

but does not make the winning o¤er incurs the cost of the agent’s wages and M , if applicable. So,

the principals randomize over their o¤ers on a compact support, the bottom of which is I . As long

as N is low enough that an o¤er of I results in weakly positive pro…ts even if every principal hires

an agent, then = 1. When N rises above this threshold, principals randomize over the decision

to hire an agent, so < 1.

Obviously, the relative costs of delegation and centralization may be such that only one organi-

zational form is used in equilibrium. However, the implication of Proposition 6 is that the relative

cost of delegation increases with the probability of being outbid. Therefore, where the pro…tabil-

ity of the two forms is su¢ ciently "close," both are used, centralization for low o¤ers (where the

probability of being outbid is high), and delegation for high o¤ers (where the probability of being

outbid is low). Figure 2 provides an illustration.

So does competition bene…t the sponsor? Only up to an N < 1.

Proposition 8 As N increases, the expected winning o¤ er increases until such point as …rms make

zero pro…ts in expectation. The expected winning o¤ er decreases with further increases in N . The

N where the expected winning o¤ er is at its maximum is either the lowest N where …rms make

zero pro…ts in expectation or such N minus one.

Proof. See Appendix.

This result arises from two o¤setting e¤ects. Competition not only reduces the ability of …rms to

extract project surplus from the sponsor but also increases the risk that a …rm will occur evaluation

costs yet not be able to undertake the project, because a competitor has made a better o¤er. The

…rst e¤ect dominates until the …rms are no longer making positive pro…ts from the project. Then,

the second e¤ect dominates, because …rms must earn more per project undertaken to cover the

rising probability of incurring evaluation costs in vain. Thus, the optimal level of competition

from the sponsor’s perspective is where there are enough competing …rms to bid up o¤ers to the

15
 Vd

Fd

Vc = Vd

Fc

ID = Vc
Figure 2: Distribution of O¤ers

16
zero-pro…t level. Introducing more competition beyond that point lowers average o¤ers.

For similar reasons, competition changes the relative propensity of principals to adopt one

organizational form versus the other.

Proposition 9 As N increases, the measure of principals who centralize ( ) is weakly increasing

in N and strictly increasing in the range where 2 (0; 1).

Proof. See Appendix.

The intuition is as follows. Consider a situation where the principal of a monopoly …rm (N = 0)

would delegate. As we increase the number of competing …rms, the probability of winning the

project with a low o¤er (near I ) decreases, disproportionately reducing the pro…tability of dele-

gation. If M is not too large, principals start to randomize between organizational forms, using

centralization for lower o¤ers. As N rises further, the proportion of principals who centralize con-

tinues to increase until we reach the level of zero pro…ts. Then, further increases in N decrease the

average o¤er; but since lower o¤ers are associated with centralization, the proportion of principals

who centralize continues to rise. In other words, in the range of N where …rms make positive

pro…ts, the greater sensitivity of delegation to the possibility of being outbid prompts principals

to shift to centralization as N increases; in the range of N where …rms make zero pro…ts, the need

to compensate for the increasing probability of being outbid prompts principals to o¤er less when

they opt to compete at all, shifting o¤ers toward the lower values associated with centralization.

We thus have a clear empirical prediction that competition is associated with a higher incidence

of centralization. Moreover, competition leads to a diversity of organizational forms, even without

di¤erent ex ante competencies among organizations.

Lastly, one could imagine a situation where the principals know for certain how many com-

petitors are in a position to make o¤ers for a project. This situation could arise if the sponsor

was known to have solicited o¤ers from certain …rms. In this case, the equilibrium operates very

similarly to the one described above, with the exception that as soon as there is more than one …rm,

principals randomize over the decision to hire an agent and the expected winning bid is decreasing

in N for all N > 1. In such a competitive environment, a sponsor should solicit o¤ers from two

and no more than two …rms.

17
4 Economic Conditions

It seems reasonable that the proportion of good projects ( ) would be a good proxy for economic

conditions. Indeed, economic conditions have been modeled this way in the literature on banking,

in which context the project’s sponsor would be a borrower. For example, in a recent paper on

how bank lending standards change in response to ‡uctuations in the business cycle, Ruckes (2004)

assumes that the proportion of borrowers who are creditworthy is positively associated with the

state of the economy. In this model, there is an inverse U-shaped relationship between and the

relative pro…tability of delegation.

Proposition 10 Under either monopoly or competition, 9 2 (0; 1) where the relative pro…tability

of delegation versus centralization is maximized. If delegation is more pro…table than centralization

at , then 9 ; such that 0 < < < < 1 and centralization is strictly more pro…table than

delegation for all 2 0; [ ( ; 1).

Proof. See Appendix.

The mathematical intuition for this result is that as approaches 0 or 1, the spread in wage

outcomes under delegation becomes more extreme, magnifying the impact of the agent’s limited

liability constraint. The economic intuition is that the less "meaningful" the agent’s evaluation, the

more high-powered the incentives required to induce the agent to undertake it. In other words, as

moves closer to 1 (respectively, 0), it becomes more and more likely that the project is (respectively,

is not) good; therefore, it becomes progressively more expensive to induce the agent to exert costly

e¤ort rather than exerting no e¤ort and, respectively, accepting blindly or rejecting blindly and

collecting the reservation payment. In the limit, as ! 0 or ! 1, delegation becomes in…nitely

expensive.11 The question is then whether there is an intermediate value where delegation is

optimal. Figure 3 depicts that situation. If such a exists, the implication is that the …rm will

shift systematically from centralization to delegation and back to centralization as the economic

cycle moves from trough to peak.12

11
It is also true that if becomes close enough to 0 or 1, it will not be optimal for the principal to evaluate at
all, instead rejecting blindly in the former case and accepting blindly in the latter. This is a central point of Ruckes
(2004).
12
Economic conditions may a¤ect other parameters as well. For example, in recession, H (I) might shift in some
fashion toward the bottom of its support. The e¤ect on the relative costs of delegation and centralization is indeter-
minate.

18
 Evaluation Costs

Delegation

Centralization
e+M

0 L LD L 1 L

Figure 3: Comparison of Evaluation Costs as Varies

19
5 Project Similarity

We would expect the di¤erence between good and bad projects to be small in some business

environments, in which case the added value from evaluating the project would be low, and in

other cases large, making project evaluation crucial. In our model, the di¤erence between good

and bad projects is operationalized by the parameter d. As the di¤erence between good projects

(d = d) and bad projects (d = d) shrinks, there is a monotonic decrease in the relative pro…tability

of delegation vis-à-vis centralization.

Proposition 11 Under either monopoly or competition, as d increases (or d decreases), holding the

other parameter values …xed, the relative pro…tability of delegation vis-à-vis centralization declines.

Proof. See Appendix.

As with the analysis of above, the mathematical intuition of this result is that when d increases

(or d decreases), the denominator in the wage payments under delegation decreases, making the

spread in wage outcomes larger and thereby increasing the bite of the agent’s limited liability

constraint. From an economic point of view, the result is also intuitive. As d approaches d, the

agent is being asked to make an increasingly …ne distinction between good and bad projects, thus

requiring a progressively more high-powered, and thus more expensive, combination of incentives.

6 Discussion

The paper’s results give rise to …ve distinct sets of empirical implications. First, delegating …rms

o¤er better terms to project sponsors than centralizing …rms to reduce the probability that the o¤er

will be refused. This result obtains both in a monopoly setting and where delegating and centralizing

…rms compete with each other. Thus, in the M&A market, for example, we should expect to see

…rms that have delegated acquisition authority to, say, a divisional or regional manager o¤er higher

prices to target shareholders than …rms that retain that authority at headquarters. To the extent

that project sponsors can choose, moreover, they should position themselves to do business with

delegating …rms.

Second, as the number of competing …rms increases, the relative pro…tability and incidence of

centralization increase. In banking, then, where the selection of projects for investment is a core

20
activity, we should observe greater use of centralized lending procedures like quantitative credit

scoring in competitive banking markets than in markets with only a few banks. Furthermore, it

also follows that informationally-opaque segments of the loan market where centralized quantitative

credit scoring is not feasible (like highly-leveraged or small business loans) should have relatively

few competing banks and be regional, whereas markets amenable to quantitative techniques (like

US home mortgages or credit cards) should have a large number of geographically-dispersed com-

petitors.13 This is what we observe. More generally, we should expect companies to shift from

delegation to centralization and back as markets become more and less competitive.

Third, there is an inverse U-shaped relationship between the number of …rms competing for a

project and the relative favorability of the terms o¤ered the project’s sponsor, be it a seller, investee,

or borrower. This means that suppliers of strategic factors and other opportunities for investment

should position themselves in markets that are moderately, but not excessively, competitive. This

is a twist on the classic view in strategy that competition among counterparties bene…ts the focal

…rm (Porter, 1979). In the model herein, competition is only bene…cial up to the point where the

counterparties are no longer capturing any rent from the transaction. Beyond that, competition is

a lose-lose game.

Fourth, delegation is relatively pro…table at intermediate levels of economic "muni…cence,"

while centralization is relatively pro…table when economic conditions are particularly good or bad,

suggesting …rms should follow a systematic pattern of reorganization across the business cycle. In

addition, this result explains a known empirical regularity in banking. There is a wealth of evidence

that banks tighten credit standards in recessions and that the credit tightening disproportionately

a¤ects informationally-opaque borrowers. Speci…cally, bank lending, in relative terms, ‡ows away

from small …rms to large (Gertler and Gilchrist, 1993) and away from riskier to safer credit risks

(Lang and Nakamura, 1993). While a number of theoretical explanations have been advanced

to account for the apparent procyclicality of bank lending, none account for the disproportionate

impact on informationally-opaque borrowers.14 Herein, the empirical regularity follows naturally

13
Centralized lending is said to rely on a borrower producing "hard," veri…able information like …nancial statements
that can be assessed using quantitative metrics, as opposed to "soft" information like the character of a borrower’s
managers. See Allen, DeLong, and Saunders (2004) for a summary of commonly-used quantitative metrics in credit-
scoring models. Liberti and Mian (2006) present evidence that loan decisions made at lower levels of a bank’s
hierarchy rely more on qualitative "soft" information than loan decisions made at higher levels.
14
Bernanke, Gertler, and Gilchrist (1996) point out that smaller borrowers are more likely to provide collateral in
respect of their loans and relate this to theoretical models where lending is constrained by the net worth of potential

21
from the paper’s result that delegated lending is not cost e¤ective in recession and the fact that

informationally-opaque borrowers are by de…nition ill-suited to centralized lending.

Fifth, the …ner the distinction between good and bad projects, or, alternatively, the less mean-

ingful the project evaluation, the greater is the relative cost of delegation. This not only relates the

choice between delegation and centralization to the overall topography of the business landscape,

but also leads to speci…c empirical predictions. For instance, in the investment grade loan market,

we might expect the default probabilities between good and bad lending opportunities to be small,

because the rating agencies are providing an initial screen of borrowers which a bank may only be

able to re…ne modestly. In this case, centralized lending is likely to be pro…t-maximizing. In con-

trast, the market for strategic factors should often be characterized by large di¤erences in project

quality, where a well-considered project may lead to several years of supernormal pro…ts but an ill-

judged project to bankruptcy. In these circumstances, delegation is likely to be pro…t-maximizing.

The foregoing implications may also be recast in terms of …rm performance. For example,

delegation and aggressive competition together comprise an ideal strategic con…guration and should

result in better …nancial performance than, say, centralization and aggressive competition. A

contribution of the paper is that it makes recommendations about what the ideal combinations

of strategy and organizational form are given the environment, rather than inferring that what is

generally observed empirically is necessarily ideal.

Finally, the paper’s results give rise to a number of intriguing questions. For instance, it

would be interesting to examine whether project sponsors adapt their pro…le over time to the

organizational form adopted by buyers and other suppliers of capital. One could also study the
borrowers (Bernanke and Gertler, 1989, 1990). The argument is that the lower borrower net worth is, the greater
the risk-shifting agency costs associated with borrowing, and since borrower net worth is presumably lower when the
economic outlook is bleak, recessions may curtail bank lending. If, indeed, borrower net worth is more relevant for
informationally-opaque borrowers, a decline therein could account for the phenomenon in question. But a borrower’s
net worth provides downside protection to lenders regardless of whether the assets connected therewith have been
assigned as collateral or not. The chief virtue of collateral is that it prevents the borrower from liquidating the
secured asset and using the funds in a way that jeopardizes repayment of the loan. If one loan to a borrower is
secured and another loan is not, the secured loan will be repaid …rst with the proceeds of the security’s liquidation.
Now, it is well known that small borrowers use fewer lenders (Detragiache, Garella, and Guiso, 2000). Where a small
business uses only one bank, there is obviously no con‡ict among lenders over the assignment of collateral, but the
multiple lenders to a large corporation may blanche if a select few among them have security and the rest do not.
There is a commonly-used solution to that problem, however, which combines (a) a covenant called a negative pledge,
which prevents the borrower from using its assets as collateral for other loans, with (b) other covenants that limit
the borrower’s ability to sell assets or pay dividends. In this way, the unsecured banks preserve their claim on the
borrower’s net worth. Therefore, it is not necessarily true that ‡uctuations in borrower net worth should have a
greater impact on lending to informationally-opaque borrowers than on lending to other borrowers.

22
e¤ect of prior relationships on the relative pro…tability of delegation and centralization. Delegation

may be more pro…table where the agent is "familiar" with the project sponsor through repeated

interaction. There may also be interesting extensions in multitasking. For example, the manager

of a subsidiary might have an incentive to work harder at general management if the manager had

the authority to authorize capital for projects that arose in the normal course of business. These

extensions must await future research.

7 Appendix: Proof of Propositions

Derivation of Optimal Wage Payments for Delegation (Limited Monopoly): The principal must

solve the following program, where functional arguments have been supressed and wdQ is the wage

that the agent receives if the o¤er is refused by the sponsor:

maxwdH ;wdQ ;wdR ;wdL d = q [(R wdH ) (1 d) wdL d ] (1 q) wdQ (1 ) wdR s.t.

q [wdH (1 d) + wdL d] + (1 q) wdQ + (1 ) wdR e 0 (IR)

q [wdH (1 d) + wdL d] + (1 q) wdQ + (1 ) wdR e wdR (IC 1)

q [wdH (1 d) + wdL d] + (1 q) wdQ + (1 ) wdR e (IC 2)

q [wdH (1 d) + wdL d] + (1 ) q wdH 1 d + wdL d + (1 q) wdQ

q (wdH (1 d) + wdL d) + (1 q) wdQ wdR (IC 3)

q wdH 1 d + wdL d + (1 q) wdQ wdR (IC 4)

wdH ; wdQ ; wdR ; wdL 0

The IR constraint re‡ects the agent’s option to refuse the wage contract. IC 1 means the agent

does not shirk and collect the reservation payment with certainty. IC 2 means the agent does not

accept the project without screening. IC 3 and IC 4 ensure the agent will make a good decision

once the project’s type has been determined. Since d > d, IC 3 and IC 4 collectively mean that

wdH > wdL . IC 1 makes IC 3 redundant, and IC 2 makes IC 4 redundant. Rewriting IC 1 and IC

2 yields:

wdR (1 q) wdQ e
wdH (1 d) + wdL d +
q q
wdR (1 q) wdQ e
wdH 1 d + wdL d
q (1 )q

23
If the IR constraint binds, IC 1 must also bind, because wdR cannot be negative. This implies

that wdR = 0, which violates IC 2. Thus, the IR constraint must be slack. It is then evident from

the rewritten forms of IC 1 and IC 2 and the agent’s risk neutrality that we may, without loss of

generality, set wdQ = wdR . We then have wdH wdR wdL . It then follows that if IC 1 is slack,

the principal could raise wdR and lower wdH without lowering the objective function. Likewise,

if IC 2 is slack, the principal could raise wdL and lower a combination of wdR and wdH without

lowering the objective function. It is therefore weakly optimal for IC 1 and IC 2 to bind and for

wdL to equal zero. We thus have the following system of equations:

e
wdH (1 d) = wdR +
q
e
wdH 1 d = wdR ,
(1 )q

which has the solution given in the text.

Derivation of Optimal Wage Payments for Delegation (Competition): The principal must solve

the following program:

maxwdH ;wdQ ;wdR ;wdL d = q [(R wdH ) (1 d) wdL d ] (1 q) wdQ (1 ) wdR s.t.

q [wdH (1 d) + wdL d] + (1 q) wdQ + (1 ) wdR e 0 (IR)

q [wdH (1 d) + wdL d] + (1 q) wdQ + (1 ) wdR e wdR (IC 1)

q [wdH (1 d) + wdL d] + (1 q) wdQ + (1 ) wdR e (IC 2)

q [wdH (1 d) + wdL d] + (1 ) wdH 1 d + wdL d + (1 q) wdQ

q (wdH (1 d) + wdL d) + (1 q) wdQ wdR (IC 3)

wdH 1 d + wdL d wdR (IC 4)

wdH ; wdQ ; wdR ; wdL 0

The constraints have the same meaning as in the derivation of the wage payments for delegation

under limited monopoly. Again, wf H > wf L , IC 1 makes IC 3 redundant, and IC 2 makes IC 4

24
redundant. Rewriting IC 1 and IC 2 yields:

wdR (1 q) wdQ e
wdH (1 d) + wdL d +
q q
e
wdR wdH 1 d + wdL d
(1 )

By an identical argument to the one used to derive the wage payments for delegation under limited

monopoly, the IR constraint is slack; we may, without loss of generality, set wdQ = wdR ; we have

wdH wdR wdL ; and it is weakly optimal for IC 1 and IC 2 to bind with wdL equal to zero,

yielding:

e
wdH (1 d) = wdR +
q
e
wdH 1 d = wdR ,
(1 )

which has the solution given in the text.

Proof of Proposition 7: First, note that from a given principal’s perspective, the probability that

another particular …rm is not competing for the same project is 1 + (P 1) =P . Therefore,

the probability distribution of the number of additional o¤ers n for that project is described by a

variant of the binomial distribution:

N n
N! n P
n
n! (N n)! P P

Let us now establish that the principal will make an o¤er according to a continuous o¤er function

F ( ) de…ned on a compact support. Leave aside for a moment the issue of which organizational

form the principal adopts. Assume …rst that = 1. This means the …rms must be earning (weakly)

positive pro…ts in expectation from hiring an agent to pursue a particular project. De…ne as

the lowest return a …rm can receive with probability 1 (under either centralization or delegation,

whichever would result in a higher o¤er) and still earn the pro…ts in expectation that the …rm

would receive from o¤ering I and winning with probability [(P 1) =P ]N . The well-known logic of

Bertrand competition means that it cannot be an equilibrium for the principals to o¤er a particular

< with positive probability, as the principals would have a pro…table deviation to + . There

25
cannot be a mass point at either, since a principal could pro…tably deviate by transferring the

mass to a strictly positive number greater than or equal to I . Nor are there any gaps in the support
0 00 00
of F . Suppose, by way of contradiction, that there were an interval ; (with < ) where F 0

was 0. Then, given that there are no mass points in the support of F , there must be an > 0 such

that each principal would …nd it pro…table to transfer the probability measure of its o¤er function
00 00 0
from the interval ; + to , a contradiction. Now, the top of the support of F must be ,

for, otherwise, a principal could pro…tably deviate by making an o¤er just above the support of F ;

and the bottom of the support of F must be I , because the …rm will only win with an o¤er of

if it is the only …rm pursuing a particular project, in which case the most pro…table o¤er is the

pro…t-maximizing o¤er when N = 0, which, given the common reservation price of borrowers, is

I .

If, instead, < 1, the …rms must be earning zero pro…ts in expectation. In this case, de…ne

as the lowest return a …rm can receive with probability 1 (again, under either centralization or

delegation, whichever would result in a higher o¤er) and still earn zero pro…ts in expectation. The

characterization of F proceeds precisely as above with the exception that the reason there cannot

be a mass point at now is that, if there were, …rms would lose money in expectation from an o¤er

of .

Let us turn to the choice between delegation and centralization. It is evident that the relative

cost of the organizational forms may be such that, in equilibrium, only one is used, i.e., equals

0 or 1. Consider a potential equilibrium where every principal (who hires an agent) centralizes.

Starting from an o¤er of I , as increases, Fc increases and thus q increases at precisely the rate to

keep the focal …rm’s expected pro…t constant. But we know from Proposition 6 that as q increases,

the relative pro…tability of delegation rises. Therefore, the most pro…table deviation for a principal

in such a potential equilibrium is to delegate and bid . Conversely, in a potential equilibrium

where every principal who hires an agent delegates, the most pro…table deviation is to centralize

and bid I .

Proposition 6 also implies that the supports of Fc and Fd cannot overlap, because the blended

o¤er function F cannot simultaneously keep the pro…tability of both organizational forms equal

as changes. Therefore, given the relative pro…tability of delegation at high q, the support of Fd

must be above that of Fc if 2 (0; 1).

26
 We now show that symmetric equilibria are unique (modulo null set transformations of F and

ignoring knife-edge subsets of the parameter values). First, if N is small enough that each …rm earns

positive pro…ts with an o¤er of I , then = 1 in equilibrium. If N is so large that, if = 1, …rms

would earn negative pro…ts with an o¤er of I , then must be such that q (I ) = [(P ) =P ]N is

large enough that …rms earn zero pro…ts in expectation at a bid of I . Thus, is greater than 0,

less than or equal to 1, and uniquely determined. Now, consider . If it is an equilibrium for every

principal to delegate, then a deviation to centralization with an o¤er of I results in lower expected

pro…ts. Thus, in another candidate equilibrium where every principal centralizes with positive

probability, would be lower or would be lower, meaning that a deviation to delegation and an

o¤er of would be pro…table. Likewise, if it is an equilibrium for every principal to centralize, then

a deviation to delegation and an o¤er of results in lower pro…ts. This implies is higher than the

zero-pro…t o¤er under delegation (if one exists) in a candidate equilibrium where every principal

delegates with positive probability. Suppose, then, that there is no equilibrium with equal to 0

or 1, because centralization is more pro…table with an o¤er of I , but there is a pro…table deviation

to delegation and an o¤er of in any candidate equilibrium where every principal centralizes.

d c is thus positive at (as de…ned under delegation) and negative at some lower value. By

the continuity of both d and c in q, the di¤erence between these two functions must also be

continuous. Then, by the intermediate value theorem, there must be a q such that the di¤erence is

0. Speci…cally, that q is [(P (1 ) ) =P ]N , which de…nes .

Proof of Proposition 8: We have seen in the proof of Proposition 7 that = 1 as N increases

from 1 to some N 0 1 and then decreases as N increases further. Let F N be the equilibrium o¤er

function F when there are N + 1 principals. Suppose = 1. Since the expected pro…ts of each

…rm are declining in N , if N increases from N 1, the top of the support of F N is above that of

FN 1, and q ( ) declines for all within the support of F N 1. To analyze the range of N where

< 1, we need the following Lemma:

1 ax
Lemma 12 A function of the form 1 bx , where 0 < b < a < 1 is increasing in x; 8x > 0.

Proof. Taking logs yields ln (1 ax ) ln (1 bx ). Di¤erentiating this with respect to x yields

ax ln a bx ln b
+
1 ax 1 bx

27
We will demonstrate that this expression is always positive. Consider the derivative of the second

term of the expression in respect of b:

xbx 1 ln b bx 1 bx 1 x ln b
+ = +1
(1 bx )2 1 bx b 1 bx 1 bx

Signing this a matter of signing the term in parentheses. Applying L’Hôpital’s rule gives

x ln b x=b
lim = lim = 1
b!1 1 bx b!1 xbx 1

x ln b
There is no solution to 1 bx + 1 = 0 for any b 2 (0; 1). To see this, note that equality requires

that x ln b = bx 1. This occurs at b = 1. The derivatives of the two functions at that point are

x=bjb=1 = x and xbx 1j

b=1 = x. Otherwise, the …rst term is larger since 1 > bx . Thus, x ln b is
ax ln a bx ln b
strictly less than bx 1 8b 2 (0; 1). We can therefore conclude that 1 ax > 1 bx , and since

both the terms inside the absolute value brackets are negative, we have our result.

Now, notice that if N N 0 , q does not change for any given , because q is precisely the q that,

given , results in zero pro…ts in expectation. Thus, we can solve for in terms of q at a bid of I :

[(P ) =P ]N = q (I )
1
(P ) =P = q (I ) N

Likewise, if we let G ( ) = 1 F ( ), we can solve for G ( ) in terms of q ( ):

[(P G ( )) =P ]N = q( )
1
1 q( ) N
G( ) = 1
1 q(I ) N

Now, let Gmax ( ) be the the probability that at least one o¤er is greater than or equal to for a

particular project given that there is at least one o¤er made.

1 [(P G( ))=P ]N +1
Gmax ( )
1 [(P )=P ]N +1
N +1
1 q( ) N
= N +1
1 q(I ) N

N +1
This has the form of the function in the foregoing lemma, so increasing N (which lowers N for

28
N 1) lowers Gmax ( ) 8 .

Clearly, this shift in the weight of the cumulative distribution of Gmax ( ) as N increases beyond

N 0 has the e¤ect of decreasing the expected value of the winning o¤er conditional on an o¤er being

made. Without an integer constraint on N , N would be precisely the "number" of …rms where

…rms earned zero pro…ts in equilibrium. Given the integer constraint, the number N where the

conditional expected value of the winning o¤er is highest is either N 0 or the smallest integer less

than N 0 .

Proof of Proposition 9: There are two cases to consider. Let N 0 be as de…ned in Proposition 8

and suppose N N 0 , i.e., that < 1. As shown in the proof of Proposition 8, q ( ) is constant for

all where N N 0 (implying c = d is invariant) and

1
1 q( ) N
G( ) = 1
1 q(I ) N

1
We may then reapply Lemma 12 to see that as N increases (and thus N decreases), G ( ) decreases

8 . In then follows from the fact that the support of Fd (if it exists) is above that of Fc (if it exists)

that the measure of principals who centralize ( ) either remains 0 (all principals delegating) or 1

(all principals centralizing) or increases. Suppose, instead, that N is in the range where = 1.

If every principal is delegating, increasing N will either prompt principals to randomize between

organizational forms or over the decision to hire an agent. In the latter situation, we return to the

case where < 1; in the former, has increased. If the principals are already randomizing between

forms, we know from Proposition 7 that the probability of winning with an o¤er at the junction of

the supports of Fc and Fd is [(P (1 ) ) =P ]N . This probability cannot change as N changes,

because it represents the q where the pro…tability of the two organizational forms is equal. Since

this expression is decreasing in N , must approach 1 from below to compensate.

Proof of Proposition 10:

Limited Monopoly: The formula for the di¤erence in wages between delegation and centraliza-

tion can be written as

e 1 d d d
+
d d q (1 ) (1 )

This expression converges to 1 as approaches 0 or 1. Di¤erentiating the expression with respect

29
to yields
!
d e 1 d d d e 1 d d d
+ = (2 1) +
d d d q (1 ) (1 ) d d q (1 )2 2 (1 )2

The derivative is clearly continuous where 2 (0; 1). Thus, if there is one and only one where

the derivative equals zero on 2 (0; 1), such a point must represent a minimum with the relative

cost of wages under delegation rising monotonically to 1 as decreases (increases) from to 0

(1). We now show this is the case. Setting the derivative equal to zero yields the following quadratic

expression
2
d d +2 1 d 1 d =0

Therefore, by the quadratic formula:

q
1 d 1 d (1 d)
=
d d

The lesser root is negative. The greater root is larger than

q
1 d + 1 d 1 d
=0
d d

and smaller than p

1 d + (1 d) (1 d)
=1
d d

Competition: Proceeding as above, we rewrite the formula for the di¤erence in wages thus:

e 1 d (1 d) q
+
d d q (1 )

Di¤erentiating the expression with respect to yields

!
d e 1 d (1 d) q e 1 d (1 d) q
+ = +
d d d q (1 ) d d q 2
(1 )2

30
Following the same logic, we set this to zero, yielding

2
(1 d) q 1 d +2 1 d 1 d =0

If (1 d) q 1 d = 0; = 1=2. Otherwise, the roots are

q
1 d 1 d (1 d) q
=
(1 d) q 1 d

q
Let s = 1 d (1 d) q. There are two cases to consider. Suppose (1 d) q 1 d < 0.

Then, (1 d) q < s < 1 d . Thus,

1 d +s
2 (0; 1)
1 d + (1 d) q

and
1 d s
>1
1 d + (1 d) q

Suppose, instead, (1 d) q 1 d > 0. Then, (1 d) q > s > 1 d . Thus,

1 d +s
2 (0; 1)
1 d + (1 d) q

and
1 d s
<0
1 d + (1 d) q

Proof of Proposition 11:

Limited Monopoly: The formula for the di¤erence in wages between delegation and centraliza-

tion can be written as !

1 d 1
e +
d d (1 ) q (1 )q

Di¤erentiating the expression with respect to d yields

!!
d 1 d 1 e 1 d
e + = 2 >0
dd d d (1 ) q (1 )q d d (1 ) q

31
 Di¤erentiating the expression with respect to d yields
!!
d 1 d 1 e (1 d)
e + = 2 <0
dd d d (1 ) q (1 )q d d (1 ) q

Competition: Proceeding as above, we di¤erentiate the formula for the di¤erence in wages from

the body of the paper:

!
d e 1 d (1 ) + (1 d) q e 1 d (1 + q)
= 2 >0
dd d d (1 ) q d d (1 ) q

and !
d e 1 d (1 ) + (1 d) q e (1 d) (1 + q)
= 2 <0
dd d d (1 ) q d d (1 ) q

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