1995Working Paper No. 1346
This paper presents a theory of endogenous internal organization in a multiagent hierarchy charcterized by incomplete information in which independent agents produce complements and have an opportunity to form an alliance through which they share their information and interact with a principal as a single entity. The alliance is formed through a contingent compensation agreement that, as a result of limited liability, affects the individual rationality conditions for the agents and the alliance. This makes the agents better off than if they contracted independently with the principal, and hence they prefer to form an alliance. The principal may also prefer that an alliance form because it benefits from the better coordination of production achieved through the alliance. In an example, both the agents and the principal are shown to be strictly better off due the endogenous formation of an informational alliance. A principal thus may be able to delegate the organization of a supply chain or the internal organization of a firm to the agents rather than designing the organization form the top down.