The firm and managerial misdirection of worker effort

CARL R. GWIN [*] This article models how a level of management between workers and the owner of a firm can affect the owner's decision either to internally integrate a function to make inputs or to contract out to buy inputs from an independent supplier. In the model, a self-serving manager can direct her workers to perform activities that serve her interests rather than those of the firm. This reduces the effectiveness of worker performance incentives intended to promote efforts that benefit the owner. Incentives may have to be increased to a level such that the owner prefers to buy inputs rather than make them internally. (JEL L22) I. INTRODUCTION How does a level of management between workers and the owner of a firm affect the owner's decision either to internally integrate a function to make inputs or to contract out to buy inputs from an independent supplier? When analyzing the make-or-buy decision, the literature has focused on various factors that differentiate direct employment from contracting with an independent supplier. Different papers have emphasized different factors. All have a common thread of examining the efficiency of integrating some function into the firm based on an analysis of the contracting relationship between the firm and its workers. However, previous analysis has excluded the role of the links that bind an organization together, namely managers. A manager may be given the authority to supervise a worker if the manager's cost of monitoring the worker's efforts is less than that of the owner. In incentives modeling, including a manager who uses her authority to benefit the owner has little if any effect on the decision to integrate. [1] A manager who shares the objectives of the owner simply reinforces the factors that can play a part in the owner's decision. The contribution of this paper is in recognizing that the inclusion of a manager who uses her authority to benefit herself can alter the owner's decision. [2] In my model, managers can set rewards to induce workers to perform tasks that are valuable to the manager but not to the firm. A key result is that a level of self-serving management between an owner and a worker can reduce the effectiveness of performance incentives intended to influence the worker's effort. The principal responds by increasing the worker's performance incentives. Previous literature has found that high-performance worker incentives are consistent with the decision to buy. This article concludes that a firm is more likely to externalize a function if an internal managerial hierarchy interferes with the performance incentives that motivate production by direct workers. Readers familiar with the literature may wish to skip the literature review and continue to Section II. Section II develops a model of managerial misdirection of worker effort. Section III concludes. Literature Review The choice between direct employment of the inputs to production and contracting with an independent supplier to purchase inputs is a fundamental building block in answering the question of why firms exist at all. The previous literature has maintained that if we understand the factors that lead to an owner's choice of internal employment, then we also better understand why firms exist. Holmstrom and Milgrom (1994), hereafter referred to as H&M, criticize previous theories of the firm because they typically examine only a single incentive instrument in a firm's choice between direct employment and contracting. Alchian and Demsetz (1972) and Holmstrom (1982) focus on principal-agent issues and compensation. Williamson (1985), Grossman and Hart (1986), and Hart and Moore (1990) deal with a firm's ownership of assets. Coase (1937) and Simon (1951) emphasize the firm's authority to direct the activities of its workers. In practice, we observe that high-performance labor incentives (workers are paid commissions, use their own tools, and make their own decisions) are all consistent with the decision to contract out a function to an independent supplier or contractor. …