DP2839 Hierarchy Size and Environmental Uncertainty

Author(s): Kieron J Meagher, Hakan Orbay, Timothy Van Zandt
Publication Date: June 2001
Keyword(s): Bounded Rationality, Decentralisation, Hierachies
JEL(s): D23, D83
Programme Areas: Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=2839

We examine how a firm's changing environment and the information constraints of its managers interact as determinants of the size of the firm's administration. Following the recent decentralised information processing literature, we assume that it takes individual managers time to process information. A consequence is that it takes time for a firm to aggregate information, even when this task is shared. This delay increases with the amount of information that is aggregated, leading to the following trade-off: the more data the firm samples each period (and hence the larger its managerial staff), the more precisely it can estimate the state that its environment was in when the sample was taken but the more the environment has changed by the time these data are used to estimate the current state. We explore this trade-off for two computation models and for both a benchmark case of costless managers and the case of costly managers. When managers are costless, the size of the administrative staff increases monotonically, as the environment becomes more stable. In contrast, when managers are costly, optimal managerial size first increases and then decreases as a function of environmental stability.