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Faculty & Research


Market Contingent Managerial Hierarchies

Working Paper
The authors present a formal model of how the size of a firm’s administrative staff depends on the environment in which it operates. They consider a monopolist that introduces a new product in the face of market uncertainty. In a model that incorporates an information processing view of the managerial hierarchies into a product choice problem, the authors relate optimal size of organizations to the speed of change in market conditions and to more standard parameters of demand. The authors show that faster-changing environments lead to smaller management structures, which is consistent with anecdotal evidence of both flattening and decentralization by firms in response to faster-changing consumer tastes. When the environment is changing more quickly, it is better to aggregate less information to reduce the inexorable delay that occurs even when information processing is decentralized. This occurs both for positive managerial wages and in a benchmark model of zero managerial wages. An improvement of information technology, which is considered to be an increase in the speed at which each manager can process information, has a similar effect, though it is more subtle. On the one hand, such a speedup is like a decrease in the speed of change of the environment, so that the firm processes more information. On the other hand, any fixed amount of information can be processed with fewer “person hours” and hence with fewer managers. When the managerial wage is zero, these two effects exactly cancel each other, so that management size does not depend on information technology. However, when the managerial wage is positive, the firm chooses to economize on managers when they become more productive, so that an improvement in information technology leads to a shrinking of the management size. In other results, we show that the change in the optimal size of the organization is non-monotonic in both the dispersion of consumer preferences and the “transport cost” parameter, while the optimal size increases as the consumers’ value of the product increases.

Professor of Economics