Informational Hierarchies, Self-Remedying Hidden Gaming, and Organizational Neutrality

This paper studies contracting between a principal, a prime contractor, and a subcontractor when both the prime contractor and the subcontractor have private information about their own costs of producing complementary inputs. Side-contracting between the prime contractor and the subcontractor is unobservable to the principal, which creates a hidden game in which the prime contractor has the opportunity to misreport to the principal the information it obtains from the subcontractor. The paper shows that this hidden gaming is self-remedying: the equilibrium with unobservable communication is identical to the equilibrium with observable communication. This occurs because the party that can potentially benefit from the hidden gaming - the prime contractor - prefers to commit to a subcontract that eliminates its incentive to misreport the subcontractor’s costs to the principal. This provides an extended organizational neutrality result: regardless of whether communication is observable to the principal, a hierarchical supply arrangement is equivalent to direct contracting with each of the suppliers.