Private Compensation and Organizational Design

Most of the literature on organizational design and incentives assumes public contracting. Yet most real world compensation contracts are private information, observed only by their direct signatories. This matters when agents work together to produce a joint output, because they care about each others’ incentives. In this case, the principal can gain from designating one agent “team leader,” with authority to decide, and hence observe, all the bonuses. Such “outsourcing” of contracting is never optimal with fully public contracts. With private contracts, by contrast, it raises effort by reassuring agents that the incentives provided are sufficiently strong; but it distorts effort allocation, as the team leader takes too much of the compensation budget. Even when observability is held constant, pay delegation can raise output by skewing bonuses towards more productive agents.