Communication and the Optimality of Hierarchy in Organizations

This paper studies optimal organization structures in multidivisional organizations with more than two divisions. The decisions of individual divisions need to be adapted to local conditions but also be coordinated. Information about local conditions is held by division managers who communicate strategically. In this setting, in addition to centralized and decentralized organizations, a hierarchical organization may arise in which divisions are organized into groups, and decisions are made by group managers. Our central result is that when the needs for coordination are intermediate, such a hierarchical organization performs better than centralization or decentralization. We then compare Ms-form hierarchy (in which mutually more dependent divisions are grouped together) and Mw-form hierarchy (in which mutually less dependent divisions are grouped together). Somewhat surprisingly, an Mw-form is sometimes preferred over an Ms-form hierarchy. (JEL D23, D83, L23)