Hierarchical Structures and Dynamic Incentives
Abstract: We study the optimal hierarchical structure of an organization under limited commitment. The organization can commit to its hierarchical structure, but not to long term wages. In our model, the optimal hierarchy is horizontal only for fast growing organizations with small uncertainty about the employees' efficiency. When such uncertainty is large or the organization's growth is slow, the optimal hierarchy is vertical. We show that vertical hierarchies mitigate dynamic incentive problems linked to limited commitment, and tie employees closer to the organization. Our analysis also indicates that seniority rather than merit is the decisive factor for promoting employees.