Melco Management Accounting Research
Discussion Paper Series
No.MDP2017-006

The Principal Instructs Input or the Agent Sets Input Targets:
Which is Preferable in Organizational Control?

May 2017

Toshiaki Wakabayashi
Assistant Professor, WASEDA University,
Faculty of Commerce
1-6-1, Nishi-Waseda, Shinjuku-ku, Tokyo, 169-8050, Japane-mail: t.wakabayashi@aoni.waseda.jp

The Melco Foundation
Nagoya, Japan
Discussion Paper Series of the Melco Management Accounting Research, in order to promote
the study of management accounting, has published this unfinished paper onto the Web. Pleaseobtain the permission of the author when citing this paper.

The Principal Instructs Input or the Agent Sets Input Targets:
Which is Preferable in Organizational Control?

Toshiaki Wakabayashi

Abstract
This study compares the effectiveness of top-down instructions anddecentralization when setting targets in operational efforts. Additionally, this study
explores both the content and timing of an agent’s decentralized target setting.
The study shows that a top-down target-setting regime is more desirable for the
principal than non-instructions because compensation is based on risky output
performance and also on riskless input psychological costs. Additionally, even if theprincipal can select the optimal organizational control by making the agent set a target
before or after concluding a contract, either a top-down regime or a decentralized
target-setting regime is desirable for the principal.
This study explains the rationality and flexibility of organizational control in actual
practice. It also reflects a cross-cultural psychological tendency and explains theagency’s relationship with multinational corporations.

Keywords: Organizational control, decentralization, target setting, performance
evaluation, contract theory
JEL codes: M21, M41, M52

1. Introduction
This study compares the effectiveness of top-down instructions anddecentralization from setting an input target. In this study, the input target is a prioragreement on the level of effort exerted by the subordinate (agent). Within organizations,supervisors (principals) sometimes give instructions for operational efforts to agents andoccasionally encourage agents to select levels of effort. Principals cannot observe actual1

operational efforts, therefore, such practices seem irrational from the perspective of
traditional agency theory. I examine whether top-down target setting is useful incontrolling the agent initially. If top-down target setting is useful, it could be considered
an appropriate benchmark to compare with the target setting decentralization.
Additionally, I explore both the content and the timing of the agent’s target setting,where the agent can set a target either before or after concluding a contract. Thisfacilitates the consideration of various alternatives for more precise organizational
control.
Organizations function better when the agent is evaluated based on verifiable
results.1 This is because the input effort is usually difficult for the principal to observe.
However, in practice, a principal in the organization often offers input instructions to anagent or allows the agent to set an input target to control the organization.
For example, to improve profitability, firms prioritize sales districts, seasons, or
customers. Therefore, directors often instruct managers to maintain a priority policy.
From a cost management perspective, manufacturing department heads might suggestthat middle managers comply with a working procedure to reduce spoilage in theirrespective departments. Moreover, to save the contingent loss, directors may instructmanagers to assume a risk-averse policy. These instructions are not aimed at output(performance) but input (effort). Principals give such instructions to agents because they
believe they can control the agent’s behavior through these instructions. However,principals ordinarily cannot observe the agent’s efforts and cannot confirm whether
agents comply with their instructions. Therefore, if such instructions are effective, I
speculate that the agent tends to follow the instructions offered by the principal.
Similarly, it is also conceivable that principals make agents select input targets.
For example, agents sometimes formulate survey plans or production guidelines. This
study refers to this process as the “decentralization of target selection.”
Traditionally, when determining top-down or participatory decision-making, suchas in Baiman and Evans (1983), the main point of concern is environmental information
asymmetry between the CEO and managers. In such cases, firms need a system thatconveys local information to the top quarter that has decision rights. However, some
information is difficult to convey such as the preferences of certain specific customers,
expertise knowledge, or a technique. If such information is plentiful, conveying theinformation rather than delegating decision rights to the agent is more rational (Jensen
and Meckling, 1995).
Moreover, participatory decision making enhances the motivation of lower level1

For example, Lambert (2001) surveyed plenty of literature precisely.
2managers (Zimmerman, 2016). However, if the agent is rational, that agent will likely
select the target that maximizes their own expected utility. Given the agent’s
self-interest, their selection may not necessarily maximize the principal’s utility. Then,considering the tradeoff between enhancing the motivation and opportunistic target
selection, would it be useful for the principal to decentralize target selection? For
decentralization, the principal must control the agent’s target selection, therefore, I
compare cases of decentralized target selection and top-down instruction.
Comparing the effectiveness of top-down instruction and the decentralization ofsetting an input target is theoretically and practically important. To analyze these
problems, I focus on an agent’s psychological tendency. I assume that the agent tends tofollow the input target. If the agent does not have such a tendency, instructions will notaffect the agent’s behavior as the principal cannot observe the agent’s behavior.
Similarly, the deviation of agents from their instructions is difficult to ascertain, whichmakes it impossible to punish culpable agents. Therefore, in practice, instructions aremeaningless if the agents do not have a tendency to follow those instructions. Moreover,for decentralization, some believe that the motivation to achieve targets will beenhanced. Similarly, if the agent tends to surmise the principal’s aim, the principal cancontrol the agent’s target selection.
However, no research has directly measured or proved the existence of such atendency. Only a few studies have analyzed the effects of instructions intended tocontrol an agent’s behavior.2 Therefore, I assume that the agent tends to follow the
principal’s instructions.
The deviation between (a) the principal’s instructions or the selected target andthe agent’s level of effort and (b) the agent’s target selection and the principal’s opinion
affects the agent’s utility. Research from the field of psychology indicates that
individuals feel guilty when the outcomes they select are contrary to the expectations ofothers (Baumeister et al., 1994). A principal’s instructions (or expression of opinion) to
the agent can be viewed as an explicit indication of their expectations. Some
psychology studies have empirically shown that a person who feels guilty as a result of2

A consideration of implied contracts can also provide insights into “instructions.”
Baker et al. (1994) explored the significance of both express contracts (on the basis ofverifiable standards) and implied contracts (on the basis of unverifiable standards).
Considering the possibility that deviations between instructions and actual input can bemeasured as an unverifiable subjective performance standard, this study concerns itself
with implied contracts. However, because subjective performance standards are notnecessarily related to manager instructions, implied contracts can be independently
discussed.
3

failing to meet expectations is likely to become despondent. For example, Tangney(1995) found that shame, guilt, and embarrassment have different qualities, but all ofthem cause psychological damage, and people seek to avoid these feelings.
Why does an individual experience psychological stress? One probable answer isthat some people fear that if they do not achieve something, it could exacerbate an
existing problematic situation. In addition, research from the fields of psychology andeconomics on the topic of identity support this assertion. According to Akerlof andKranton (2000), identity is the individual awareness of oneself. This definition dictatesthat identity reflects differences over a broad range of social categories including gender,
religion, ethnicity, occupation, and the company for which an individual works. Akerlof
and Kranton (2000) further hypothesized that through an awareness of belonging tothese categories, differences emerge in the manner in which people believe they should
behave. Conversely, people can feel pain when they behave in a manner that violates
their expectations of themselves. If a person has a strong awareness of being part of anorganization, that person may experience psychological stress when disobeying
instructions from a principal of that organization.
For example, Boivie et al. (2011) used an interview and a questionnaire survey toquantify the extent to which CEOs identified with their respective organizations. After
controlling for other factors, they found that organizational identification is negatively
related to a CEO’s personal use of company equipment. Personal use of company
equipment serves as a proxy for agency cost and can be interpreted as a negative
relationship between organizational identity and agency cost.
Moreover, through a review of empirical research in psychology, Baumeister et al.
(1994) concluded that guilt is derived from relationships with other parties. The authors
claimed that empathy and attachment toward another party or exclusion anxiety could
affect guilt. Therefore, it follows that agent behavior that deviates from a principal’s
instructions can induce stress.
Similarly, a deviation between the agent’s effort to meet the target and actual
effort may also induce stress. In a decentralized regime, because the agent explicitly
states their targets, failure to achieve the needed level of effort (representing a breach oftrust) can result in stress.
An agent can also experience stress when selecting targets because an agent’s
selection of targets that differs from those preferred by the principal obviously fails toachieve maximum utility for the principal. Therefore, an agent may set targets that are
similar to those emphasized in the principal’s opinion. If the principal commits toexpressing an opinion in advance, the agent predicts the opinion that the principal may
4express. The expectations of the principal and the agent are likely to be consistent.
Therefore, in this study, I presume that an agent experiences stress when that agent setsa target that deviates from the principal’s expressed opinion.
Even when experiencing stress, for an agent to engage in behavior that deviatesfrom expectations may be rational. For example, Kaplow and Shavell (1994)
demonstrated that people sometimes confess their own “illegal” behavior even if they
may be subject to punishment. Intuitively, this seems irrational, but it is rational because
to keep silent is more costly. In terms of accounting control, agents select actions that
depend on the benefits that they may derive from performance evaluations and the costs
entailed in performing the task and deviating from the targets.
Moreover, the propensity to experience stress differs according to the individual.
Harder et al. (1992) provided support for this notion showing that an individual’s
attributes and guilt-induced stress levels are correlated. Tangney (1990) developed anindicator to measure feelings of guilt and showed that differences in an individual’s
stress levels are related to their cognitive processes.
Certain studies have also analyzed the notion of varying identities. For example,
Boivie et al. (2011) showed that the degree to which a CEO identifies with theirorganization is influenced by whether the CEO is invested in the company or has along-term employment contract. Consequently, the levels of psychological attributes candiffer; these factors cause stress, and the resulting stress affects the agent’s behavior.
Based on these studies, this study assumes psychological attributes andincorporates two attributes into a single-task, single-period agency model. First, I assess
the extent to which the agent is averse to implementing the level of effort that deviatesfrom the input target. Namely, I assess the agent’s “attitude toward implementation.”
Second, this study analyzes the extent to which the agent is averse to setting an input
target that deviates from the opinion of the principal; thus, I analyze the agent’s“attitude toward target setting.”
Attitude toward implementation is realized in both top-down anddecentralization regimes. In contrast, attitude toward target setting is realized only inthe decentralization regime. Therefore, the preference for a top-down ordecentralization regime depends on these individual attributes.

2. Model2.1 Timeline
I begin by explaining the timeline of the model. In period 0, the principal selects
the top-down regime or decentralizes the target setting. In a top-down regime, the5principal proposes a contract to the agent and issues input targets in period 1. The agent
then selects an effort in period 2. In a decentralization regime, the principal has thealternative to make the agent select the target after concluding a contract (type I) or
before concluding a contract (type II).
Figure 1 Timeline
Period 2
The agent
selects aneffortPeriod 1
The principal
proposes a contract
and gives instructions
Top-down
Period 0
The principal
selects the
top-down ordecentralizati
on regime

Period 1
The principal proposesa contract andexpresses opinions
Decentralization
Period 0
The principal
selects type Ior type II
decentralizati
onPeriod 2
The
agent
selects a target
and an effort

Type I

Type II
Period 1
The principal
expresses
opinions

Period 2
The agent
selects atargetPeriod 3
The principal
proposes acontract

Period 4
The agent
selects aneffort

The principal selects type I or II in period 0. When the principal selects type I, theprincipal proposes a contract to the agent and expresses an opinion in period 1. The
agent then decides an input target and selects an effort in period 2. I assume that the
principal admits the target that is stated by the agent. When the principal selects type II,
the principal expresses opinions in period 1. In period 2, the agent states an input target.
In period 3, the principal proposes a contract. The agent then selects an effort in period
4. Type II assumes that, for example, the principal may advertise for a project manager
or a branch manager. In that case, applicants may present a blueprint for maximizing
their performance before concluding the contract. Moreover, the results of a comparisonof these decentralized cases with a top-down case are not intuitive. Therefore, I consider
a variety of decentralized arrangements in the following sections.
2.2 Basic model
The agent is risk averse and the principal is risk neutral. The agent performs one
type of unobservable effort,
which causes psychological and physical fatigue;.
is the marginal cost of the effort.
6

The principal can observe and use verifiable performance data,, such as accounting income.
is assumed to be influenced by themeasurement error . The agent receives the compensation
at the end of the term,
and the contract ends. The compensation is shown as an incentive contract
proposed by the principal and is assumed to be the linear function. A fixed salary is shown as , andindicates the incentive coefficient.
Additionally, the outcome produced by the agent’s effort is given as ,and
. After the payment of the compensation, the principal gains the residual, which can be interpreted as, for example, cash flow. Because
is realized
after the contract term has ended, it is assumed to be unusable in the incentive contract.
This study assumes an agent utility function
as follows:(1)

The principal chooses.
is the top-down regime, andisthe decentralized regime. For simplicity, this paper assumes that when the game starts,
the principal has already decided on either a top-down or decentralization regime. isthe absolute risk aversion coefficient.
is the input target. In a top-down regime, the principal decides and, ina decentralized regime, the agent decides . In this study, I assume that the principal or
the agent select to maximize their own utility.
denotes an opinion declaredby the principal under a decentralized regime.
An agent experiences stress when he or she takes an action that is in conflict withan input. However, the propensity to experience such stress differs from individual toindividual. In equation (1), this concept is expressed by. Thus,indicates
the attitude toward implementation.
is in the top-down regime, andis in thedecentralized regime.
and are not necessarily the same.
indicates theattitude toward target planning, namely, the attitude of selecting a target as close as
possible toas expressed by, or likely to be expressed by, the principal.
Moreover, I assume that the principal, through psychological surveys, canobserve, and .3 The compensation,; the cost of effort,; the cost ofdeviating from an input target in the top-down regime,; the cost of deviating
3

In reality,, andare often unobservable. However, this study focuses on theeffects of, and . Thus, this study only examines the case in which thesevariables are observable.
7

from a target in the decentralization regime,, and the cost of deviating froman opinion,; each can be measured in monetary terms and as amultiplicative separable function.
Regardless of whether they are greater than or less than, agents arelikely to experience stress. Numerous papers, such as Akerlof and Kranton (2005),
Bruggen and Moers (2007), Fischer and Huddart (2008), Heinle et al. (2012), andStevens and Thevaranjan (2010), have modeled this stress using quadratic functions;
therefore, using such a model is not unique to this study. However, the model of theseprior studies can be applied only to a top-down regime, and a decentralized regime was
not discussed. I separate the implementation and planning costs.
The utility function of the principal,
, is
(2)

.

The principal is risk neutral and receives what remains after the payment of thecompensation.

3. Top-down instructions from the principal
3.1. Equilibrium solution
First, this section considers the case in which the principal selects the top-down
regime. The agent selects the most appropriate effort subject to the contract proposed by
the principal. This situation is derived as follows.

(3)

is the density function. Equation (3) can be modified as.
If

is the certainty equivalent because

(4)

then,
.

(5)

The effort exerted to maximize (5) is given as.
The principal’s expected payoff is, whereasis acondition of the incentive compatibility (IC) constraint. Thus, the problem for the
principal is
(6)
(7)
8

indicates the reservation utility. If the reservation wage is zero, the condition
for individual rationality (IR) can be.
Therefore, we obtain Lemma 1.4
Lemma 1
In a top-down regime, an agent’s effort, ; principal instruction,
incentive contract,; and the residual are as follows:; proposed. Therefore, both the level of target and incentive
coefficient influence the agent’s effort. Further,, thus, the agent always
experiences stress, and the principal compensates for the psychological cost. Lemma 2
shows the effect ofon the contract.
Lemma 2
(1) The incentive coefficient decreases asincreases(2) The expected utility of the principal increases as.
increases.

Lemma 2 (2) shows that top-down instruction is a substitute for the evaluation of
output performance for control.
This section examines the effect of not utilizing attitudes toward implementation
within incentive contracts. Lemma 1 implies that the principal must compensate for theagent’s stress. Accordingly, the case in which the principal instructs the input target
may be inefficient. Thus, comparing
with cases in which the principal does not
set input targets and/or use attitude toward implementation within incentive contracts isimportant.
The utility function of the agent is

4

The proofs for the lemmas and propositions are shown in the Appendix.
9

.

(10)

From this, we obtain equilibriums when the principal does not consider attitudes
to implementation within an incentive contract. I refer toand compare
the results of Lemmas 1. Then, we obtain the following proposition.
Proposition 1
(1)

with

.

Proposition 1 (1) shows that setting an input target is useful for the principal.
When the principal adopts top-down instructions, the compensation is based on risky
output performance and riskless input psychological costs. This saves the risk premium.
Then, does the result change when we consider a decentralized regime?
Section 4 adds other regimes.

4. Comparison of top-down instructions and decentralization oftarget selection
4.1 Type I decentralization (setting the target after concluding a contract)
This section addresses the case of decentralized regimes. This section analyzes
the type I decentralized case, in which the principal proposes a contract to the agent andissues instructions in period 1, and the agent then states the target and selects an effort inperiod 2.
Defining the equilibrium solution of the agent’s selection of the target and effort
along with the principal’s expression of the opinion, and proposing the incentive
coefficient as
,
,
, and
, respectively, gives Lemma 3.
Lemma 3The equilibrium solution achieved under decentralized regime I will be

Here,

.

In a decentralized regime, agents do not simply work according to the instructions
received but they also select the target. Accordingly, I consider that this equilibrium
10solution is affected by the agent’s attitudes toward implementation and planning. These
results are summarized in Lemma 4.
Lemma 4
(1) Asincreases, the agent sets a higher level for the target effort and, as
increases, the agent sets a lower level for the target effort(2) Asor.

increase, the incentive coefficient selected by the principal decreases.

(3) Asorincrease, the residual obtained by the principal increases.

Lemma 4 indicates that, in case of type I decentralization, the level of the target,
the amount of actual effort, the incentive coefficient, and the principal’s utility increaseor decrease monotonically against attitudes toward target planning and target
implementation. As
increases, the deviation cost is higher causing the agent to set atarget close to the principal’s opinion. Therefore,
becomes higher. In contrast, as
increases, the agent experiences higher stress when that agent cannot achieve thetarget. Therefore, the agent decreases, which is set between this trade-off.
Additionally, as
andincrease, the incentive coefficient selected by theprincipal decreases. Therefore,
andare substitutes for the performance
evaluation in a type I decentralized regime. Moreover, Lemma 4 (3) indicates that large
andare desirable for the principal.
Then, which is more preferable for the principal, top-down or type I
decentralization? Proposition 2 shows the condition.

11

Proposition 2(1) If, then.

(2) Ifor, then,(3) When the condition of Proposition 2 (1) is satisfied, at least
Additionally, in this condition, we assume that,(a) if,must be true.
(b) if,ca be satisfied.

must be true.

Proposition 2 (1) shows conditions in which the decentralization regime issuperior to the top-down regime. The decentralization regime will be desirable if theagent’s attitude toward implementation becomes higher when the principal decentralizes
the decision to the right of target setting (). Moreover,must exceed thethreshold,. According to these conditions, they indicate that when thedecentralization regime is superior to the top-down regime, at least
must betrue.
The important point is that the desirability of decentralization can depend on
attitude toward both implementation and planning. This indicates that decentralizationof target setting can be explained from the viewpoint of individual attributes. Thereexists the case where we should not decentralize the decision to the right even if theattitude toward implementation is high. Figure 2 shows Proposition 2.
Figure 2 Separation of top-down and decentralization regimes based on proposition 2†

Decentralization
TopDown
=

1

0
0 =

12

When we use questionnaires or interviews based on psychology, we can quantify
proxies such as. Therefore, I assume that the principal can observe. However, it may be difficult for each firm to measure them accurately.
Thus, if we can ignore the accurate value of each individual attribute and focus only on
the relative scale for deciding the desirableness of top-down or decentralization regimes,
we can apply the results of this study to actual business or empirical research moreeasily. According to Proposition 2, I show such a guideline based on the relative scale ofindividual attributes:.
Table 1 A guideline based on the relative scale of individual attributes
Scale
(1)
(2)

Top-down or Decentralizated Regime
Decentralized (when Proposition 2 (1) is satisfied)
Top-down (when Proposition 2 (1) is not satisfied)Decentralized (when Proposition 2 (1) is satisfied)
Top-down (when Proposition 2 (1) is not satisfied)(3)Top-down(4)Top-down(5)Top-down(6)Top-down

In cases (1) and (2), the determination depends on thresholds. In all other cases, a
top-down regime is preferable. At least, the principal should not select thedecentralization regime whenis not lower thanand . Whereis highest, asin (4) and (6), it should be intuitively obvious that a top-down regime is preferable.
However, an important contribution of this study is to show instances where it ispreferable for a principal to issue input targets. Therefore, for the decentralization
demands to succeed, more strict conditions are required than those for the top-down
regime. Additionally, we can explain the assignment of the decision from the aspect ofasymmetry of information in organizations and the psychological attributes ofindividuals.
4.2 Type II decentralization (setting the target before concluding a contract)
This section expands the discussion. I assume that the agent set the input target
before concluding a contract, and I call this situation type II decentralization. Type II
13

assumes that, for example, the principal may advertise for a project manager or a branchmanager. In this case, applicants may present a blueprint for maximizing theirperformance before concluding the contract.
This section examines decentralized regime II. In this case, the principal issues
opinions in period 1. In period 2, the agent states the target. In period 3, the principal
proposes a contract. The agent then selects an effort in period 4.
First, the problem for the agent is derived as follows.
(11)
The agent’s certainty equivalent is.
From, the optimal effort,(12)

for the agent to choose will be(13)

The problem for the principal will be as follows.
(14)

(15)
If the reservation wage is 0, then the IR condition can be. The solution
is set as, and the target level of effort offered by the agent can bederived by solving the following.

(16)

If this solution is set as
derived by solving, the opinion expressed by the principal can be(17)
Setting this solution asallows us to obtain Lemma 5.
14

Lemma 5
In decentralized regime II, the agent’s target and effort selection and theprincipal’s proposed contract, expressed opinion, and residual will be

Here,

.

Equilibriums of Lemma 5 are not influenced by. In addition,
because the principal must offer the contract that satisfies the IR and IC conditions even
if the agent proposes any target before concluding the contract. Lemma 6 shows theeffect ofon equilibriums.
Lemma 6(1) (a) When(b) When, as

is increased, the effort is increased, as.

is increased, the effort is decreased.
(2) Asis increased, the incentive coefficient is decreased(3) (a) When, as

principal is increased(b) When.

is increased, the expected utility of the
.

or

, as

utility of the principal is decreased

is increased, the expected.

15

For the type II decentralization regime, the agent sets the target from any positive
real number such that the effect ofon equilibriums is different depending on.
However, the incentive coefficient is monotonically decreasing byindicating thatis a substitute for a performance evaluation.
When the target is higher than the threshold (), asis increased, effort isincreased. However, a target that is higher by too large an amount () causes
over-exertion as
is increased. Accordingly, the principal’s expected utility becomes
lower. Therefore, sometimes a case exists in which even if the effort is decreasing, theutility of the principal is increasing or, even if the effort is increasing, the utility of theprincipal is decreasing.
However, we must be careful thatis the expected utility of period 2,
which is after the agent proposesor just before concluding the contract.
Therefore, assuming that the distribution of, which is selected by the agent inperiod 2, is, the expected value ofin period 0,
, is

(18)

In addition, the principal must state that the agent can set any target. If theprincipal’s opinion is different from the agent’s target setting, the agent experiences
stress. Such stress motivates the agent to close the target to the agent’s opinion.
However, in the type II regime, the principal satisfies the IR condition after the agent’s
target setting, which does not work.
Then, Proposition 3 shows the condition in which the type II decentralization
regime is superior to the top-down regime.

16

Proposition 3(1) The condition in which the type II decentralization regime is superior in period 0
(

) is

Here,

(2) Ifand,is true.

Here,

Proposition 3 indicates that the condition is influenced by the agent’s attributes
and the principal’s beliefs (expectation and variance of target, which is set by the agent)
about the target. The principal can observe
immediately following the agent’s
target selection (period 2). However, the principal must make a decision in period 0. In
period 0, the principal should decide on a top-down or decentralization regime based onwhether. Therefore, Proposition 3 has uncertainty for the
principal given the principle of deciding on a top-down or decentralization regime.
Then, I show a numerical example of Proposition 3. Becausemust be apositive real number, I assume thatis lognormal distribution.
(19)
I also assume that
. Whenand, the ideal target for the principal is, which is the medianof the distribution (). According to these assumptions, I obtain(20)
Figure 3 shows.

17

Figure 3 Comparison of

and

0.08

0.06

0.04

0.02

0.2

0.4

0.6

0.8

0.02

0.04

0.06

The threshold depends on
and is approximated from.
Therefore, when I assume thatis a lognormal distribution, depending on theparameters, a case exists in which the principal can be predicted in period 0, and type II
decentralization is certainly superior to a top-down regime. Additionally, if the
distribution is more skewed, the probability is lower.

5. Comparison of target-setting timing
In this study, I show that both decentralized regimes can be superior to the
top-down regime. Therefore, in this section, I compare all of these equilibriums andexamine the decentralized regime that the principal should select.
Proposition 4(1) The condition in which the type II decentralization is superior to the type I
decentralization is

Here,(2) Asis higher,

is lower, but as18

is higher,

is higher.

(3) A top-down regime, or type I or II decentralization regimes, can be the optimalorganizational architecture for the principal.

First, Proposition 4 (1) is the condition under which type II decentralizations aresuperior to type I decentralizations. In period 0, it is stochastic. Moreover, Proposition 3(2) shows that as
is higher, type I is more desirable and, as
is higher, type II is
more desirable. This is consistent with Lemma 6 and that equilibriums of type II are notinfluenced byand Proposition 2. However, if both Proposition 4 (1) and Proposition
2 are not simultaneously satisfied, type II will not be alternatives. Proposition 4 (3)shows that both Proposition 4 (1) and Proposition 2 can be satisfied. Thus, the top-down
or types I or II decentralization regimes can be the optimal organizational architecture
for the principal.
Proposition 4 explains evidence with regard to rationality and flexibility of actual
practice. In practice, the principal controls agents based on both input and output
performance evaluation. Moreover, there are various types of instructions such as
top-down instruction, setting targets by the agent after completing a contract, and setting
targets by the agent before completing a contract. This study explains that rationality
and flexibility depend on the agent’s attributes and the principal’s beliefs.
I assume that.

Figure 4 Optimal contract for the principal
E0

𝑝

1
± E0†
2

𝑝

1
± E0††
2

𝑝

Type I

1.3

1.2

1.1

1.0

Top-down

Type II

0.9

0.8Type I

0.7

0.5

1.0

1.5

19

2.0

2.5

0

Figure 4 is consistent with Proposition 4 (3). When, the top-down regime issuperior to the type I decentralization regime. This finding is consistent with
Proposition 2. However, when we consider type II decentralization, decentralization canbe more desirable. Even if, whenandis satisfied, type II decentralization is optimal. Thatis, the value of considering type II decentralization.
Finally, Corollary 1 shows the sensitivity of the result.

Corollary 1(1) If(i) non-instruction, top-down or type I or II can be the optimalalternatives, and (ii) non-instruction and every types of decentralization are indifferent.

(2) If, (i) non-instruction, top-down, or type I, II can be the optimal alternative,and (ii) non-instruction and type I are indifferent.

If, the agent sets the same target as the principal’s opinion to minimize
the planning cost. However, the principal will not care about the target at all. This is thesame as non-instruction. In this sense, the principal does not necessarily adopt
decentralization. However, if the instruction cost is too large, decentralization can besuperior to the top-down. In this case, the principal cannot gain additional benefit fromdecentralization.
If, the agent does not experience any stress in deviating from theprincipal’s opinion. Therefore, when the agent sets a target after concluding a contract(type I), the agent sets
to minimize the implementation cost. This is the same
story as. However, when the agent sets a target before concluding the20contract, is not influenced to equilibriums. Therefore, Proposition 3 remains, and theprincipal can gain additional benefits from decentralization.

6. Conclusion
This study focuses on an agent’s two individual attributes—attitude toward
implementation and attitude toward target setting—and shows the condition where atarget-level operational effort by the agent (decentralization of target setting) is moredesirable for the principal than when the agent is instructed by the principal (top-down
target setting). In addition, I (a) analyzed whether top-down instructions are suitable forcontrolling the agent, (b) demonstrated the conditions under which the principal should
decentralize, and (c) explored both the content and the timing of the principals’
opinions.
First, setting the input target can be valuable (Proposition 1). Second, this study
shows that either a top-down regime or a type I decentralized target-setting regime isdesirable for the principal depending on the agent’s individual attributes (Proposition 2).
However, for the decentralization demands to succeed, more strict conditions are
required than those for the top-down target setting. Moreover, either a top-down regime
or a type II decentralized target-setting regime is desirable for the principal (Proposition
3). The condition is influenced by the agent’s attributes and the principal’s beliefs(expectation and variance of target, which is set by the agent) about the target(Proposition 3).
For decentralized target setting, if the agent sets the target after concluding thecontract, attitude toward target setting and attitude toward implementation can substituteperformance evaluation control (Lemma 4). In contrast, if the agent sets the target
before concluding the contract, only attitude toward implementation works as a
substitute for performance evaluation (Lemma 6). Broadly, decentralizing target setting
is also valuable for control (Lemmas 4 and 6). We infer that apart from verifiable
performance evaluation, input target setting and input instructions work toward
organizational control.
Third, I compare all equilibriums and examine the decentralized regime that the
principal should select. Then, the top-down regime or type I or II decentralization
regimes can be the optimal organizational architecture for the principal (Proposition 4).
Moreover, when we consider type II decentralization, decentralization can be moredesirable than the result of Proposition 2. That is, the value of considering type II
decentralization.
These results can explain a new mechanism for an organizational control system,
21

particularly for performance evaluation or the decentralization of decision rights. I
explain the evidence for rationality and flexibility of actual practice. In practice, theprincipal controls the agent based on both input and output performance evaluation.
Moreover, there are various types of instructions such as top-down instruction, agent
target after completing a contract, and agent target setting before completing a contract.
This study explains that their rationality and flexibility depend on the agent’s attributes
and the principal’s beliefs.
Conversely, one limitation of this study is that the assumptions pertaining to themathematical model are somewhat ad hoc. Whether individual attributes such as attitude
toward instructions and attitude toward target setting exist is unclear. However,considering the roles of such psychological factors in human behavior provides new
insights into managerial control and planning research. Thus, the results of this study
provide implications for future experimental or practical survey-based research.

22

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Appendix
Proof of Lemma 1

Thus,

The expected compensation is

Therefore, the principal problem is

To obtain the target effort,

to maximize the previous formula,can be rearranged to become

Then, to obtain the incentive coefficient,, rearranging

gives meThen,is satisfied.

Thus, I examine the 1 × 1 and 2 × 2 principal submatrixes of the Hessian matrix.

24Therefore,takes the maximal. In addition,(QED)
Proof of Lemma 2
(1)

(2)

(3)

(QED)
Proof of Proposition 1
First, I obtain. The optimal effort isThen, because

is the IC

condition. When the reservation wage is set to zero, because the IR condition canbe, Therefore, we need to solve

We obtain

Substituting each equilibrium solution obtained
.

Then,

25

(QED)
Proof of Lemma 3
First, the agent needs to solve the following problem.

The certainty equivalent of the agent becomes.
From, the optimal effort,

Additionally, solving, is, the solution,satisfy

will become. To confirm thatthese are the maximal, I examine the 1 × 1 and 2 × 2 principal submatrixes of the
Hessian matrix.

Therefore,take the maximal.
Then, the principal problem is26

If the reservation wage is set to zero, the IR condition can be
IR condition is. Therefore, the.
Substituting this forand arranging the first-order condition for

and, at the same time, arranging the first-order condition for,gives us the solution

Thus,

To confirm that these are the maximal, I examine the 1 × 1 and 2 × 2 principal
submatrixes of the Hessian matrix.

27

Therefore,take the maximal.
(QED)

Proof of Lemma 4
The results for the partial differential forandare shown as follows.

(QED)
Proof of Proposition 2

becomes the difference between the top-down regime and type I decentralization.
(1) When, the decentralized regime dominates the top-down
regime.
If all the parameters are positive, the proposition is satisfied when

(2) When, the top-down regime dominates the decentralized
regime. If all the parameters are positive, the proposition is satisfied when

Therefore, if (1) is true, at the very least,
it must be that
because28. Thus, at this time, if,

Therefore,. On the other hand, if

it can be, it must be that, thus,.
(QED)

Proof of Lemma 5First, I solve the maximization problems of formulae (16) and (17). The IR condition is.
Therefore,

becomes a quadratic concave function of

Therefore, from.

,

Moreover, from

I obtain. Thus, if any ,Therefore,
is any positive real number.
Finally, because

is a quadratic concave function for ,rearranging

I obtain(QED)
Proof of Lemma 6(1)

Therefore, rearranging, I obtain

29

(2)

(3)

Therefore, rearranging, I obtain(QED)
Proof of Proposition 3(1)is the difference between top-down and type II decentralization. Therefore, when

it becomes

All parameters are positive; it is a quadratic convex function oftype II decentralization is superior to top-down instruction.

30. Thus, when(2) Whenthe condition of Proposition 3 (1) is true, and. Therefore, it must be(QED)
Proof of Proposition 4(1)

Therefore, when

.
(2)
If

then

(3) If

31

then

Next,

thus, the condition in whichisTherefore, we consider two patterns ((a) and (b)) that depend on
optimal organizational architecture for the principal.

indicating the(a)OptimalTop-down or type I

Type I

Type II

Type I

Top-down or type I

OptimalTop or type I

TopType IITop

Top or type I

and
and

(b)
and
and

(QED)
32