The Allocation of Decisions in Organizations

This paper is motivated by an often-observed but under-studied phenomenon of the modern business enterprise, management by exception. The term describes the relative infrequency of management interference in the lower tiers of an organizational hierarchy. We study how an organization allocates decisions among agents when the efficient choice of which agent is responsible for decision-making depends on the state of the world. Two distinct factors shape the optimal scope of decision- making authority: intrinsic differences and induced differences. Intrinsic differences arise because, due to considerations of coordination, information, or incentives, one agent may have a relative advantage at making the decision in a given state. Induced differences arise because the overall quality of an agent's decision-making falls with the number of states over which he or she has discretion. Management by exception as a phenomenon may arise when scarce managerial resources are conserved by restricting the scope of managerial authority. We examine the effects of shifts in the probability distribution over states, focusing on shifts which increase the relative frequency of states where high-level decision-makers have an intrinsic advantage. We show that in response to such a shift, which might arise if the organization's environment becomes more complex, the optimal scope of low-level decision-making increases. Finally, we analyze complementarities between discretion and other organizational design variables. This paper represents a first attempt at elucidating a formal theory of state-contingent decision-making within organizations.