The optimal allocation of decision and exit rights in organizations

• DOI: http://doi.org/10.1111/1756-2171.12177
• Published date: 01 May 2017
• Author: Daniel Krähmer,Helmut Bester
• Date: 01 May 2017

RAND Journal of Economics

Vol.48, No. 2, Summer 2017

pp. 309–334

The optimal allocation of decision and exit

rights in organizations

Helmut Bester∗

and

Daniel Kr¨

ahmer∗∗

Weshow that in a bilateral relation with conflicting preferencesand transferable utility it is unam-

biguously optimal to assign the authority over project decisions to the privately informed rather

than the uninformed party. This holds irrespective of the degree of conflict and the distribution

of private information. Under the optimal contract, the uninformed party is protected by an exit

option, which it will exert when the decision maker has not chosen the promised decision. Exit

terminates the relation and diminishes the project surplus. We show that the first-best efficient

solution can be obtained by such a contract.

1. Introduction

One of the central problems in relationships such as joint ventures, partnerships, or supply

relationships is that important decisions can frequently not be contractually specified in advance

and that decision-relevant information is often held privately by some party. When contracts are

incomplete and information is hidden, determining who should have authority over decisions is

therefore among the most vital choices of contract design. The optimal assignment of authority

faces the dual challenge of restraining the self-interest of the party in authority and of providing

incentives for the informed parties to reveal their private information.

An application are research alliances where important strategic research decisions such as

what research directions to pursue, how to respond to new results, which staff to hire, etc., are,

due to transaction costs or unforeseen contingencies, impossible to fully specify in advance.

Moreover,there is often a considerable conflict of interest between the financing and the research

firm (“commercial” versus “academic”), and the research firm typically has superior knowledge

about the viability of a strategy (see Lerner and Malmendier, 2010, for evidence from the biotech

industry). Other examples arise in vertical supply relations, where contracts often specify the

∗Free University Berlin; hbester@wiwiss.fu-berlin.de.

∗∗University of Bonn; kraehmer@hcm.uni-bonn.de.

An earlier version of the article circulated under the title “The Allocation of Authority and Exit Options.” Support by

the German Science Foundation (DFG) through SFB/TR 15 is gratefully acknowledged. We thank an editor and three

referees for helpful comments. We also thank Eugen Kovac, Johannes M¨

unster, Tymofiy Mylovanov, Klaus Schmidt,

Roland Strausz, and Stefan Terstiegefor useful discussions.

C2017, The RAND Corporation. 309

310 / THE RAND JOURNAL OF ECONOMICS

authority over design choices that have to be implemented by the supplier, who has private

information about costs.

The noveltyof this article is to study the allocation of authority in relationships that can be pre-

maturely terminated. When termination is possible, exit options can be used which, as a part of the

contractual arrangement, assign the right to cease cooperation and specify provisions for this case.

In particular, we consider situations in which the parties can exchange payments conditional on

whether the relation is terminated or not.1For instance, as documented byLer ner and Malmendier

(2010), exit options of this kind are pervasive in research agreements, giving the financing firm

the right to cease collaboration and obtain the property rights from the research upon termination.

Our analysis establishes two main results. First, we show that decision rights should un-

ambiguously be given to the informed party, and exit rights should be given to the uninformed

party. This always generates a higher surplus than when the uninformed party has authority. This

finding is remarkably robust. It does neither depend on the probability distribution of the private

information, nor on the size of the parties’ conflict of interest. Second, we show that the optimal

allocation of decision and exit rights has a surprising efficiency implication: it in fact allows

implementing the first-best outcome! Thus, when the informed party has authority, the problem

of jointly providing incentives for decision making and information revelation can be overcome

as if there was no contractual incompleteness or asymmetric information.2

Our analysis supports the view that authority should be delegated to those who possess

decision-relevant information.3Reversely, weargue that the uninformed par ty should be protected

by exit rights. These findings are in line with Lerner and Malmendier’s (2010) analysis of research

agreements, which shows that the research firm enjoys considerable discretion over strategic

research decisions despite important conflicts of interest. In fact, due to the large conflict of

interest, Lerner and Malmendier (2010) consider the “pervasiveness of research agreements in

the biotechnology sector [ ...] puzzling.” Moreover, Lerner and Malmendier (2010) document

the widespread use of exit options for the financing firm and provide evidence that the use of

termination clauses is more common when research decisions are noncontractible.4

To establish our results, we allow for payments which can be fine-tuned to information

revealed by the informed party about, for instance, which decisions it plans or recommends

to take. This approach is the conceptual and normative starting point from a contract design

perspective so as to determine the efficiency frontier under a given allocation of authority. In the

practical context of research agreements, contracts of this kind arise when the research firm files

a research proposal and the payments depend on the content of the proposal. The logic behind our

main results, however, extends also to settings where report-contingent payments are infeasibleor

appear empirically implausible. In Section 5, wediscuss contracts when payments are constrained

to be contingent only on whether the project is terminated or not, and not on communication.

We argue that, under the condition that decision authority is assigned to the informed party

(and not to the uninformed party), then in a large class of settings an exit option contract can

implement the same outcome as if decisions were contractible. Thus, exit options in combination

1The feasibility of monetary payments distinguishes our article from much of the work on the allocation of decision

rights. See the literature review below.

2Wediscuss general implications for implementation in Section 5.

3There is a long tradition in economics going back to Hayek (1945) that argues in favor of delegating decisions

to individuals with “local” knowledge. For a more modern account of this view in the contextof organizations, see, for

example, Milgrom and Roberts (1992). The drawback of delegation, that decision makers act opportunistically in their

self-interest, can be traced back to Simon (1951).

4Further examples of exit option contracts comprise contracts for house remodelling, book publishing, advertising

pilot campaigns, real estate agency services, or procurement contracts for specialized equipment (see Taylor,1993; Che

and Chung, 1999). Also, performance-contingent termination clauses in loan contracts or nonpromotion clauses in labor

contracts, or certain financial contracts such as convertible bond securities can be interpreted as forms of exit options (see

Aghion, Bolton, and Tirole 2004; Kahn and Huberman, 1988; Stiglitz and Weiss,1983). An empirical analysis of control

and exit rights is provided by Bienz and Walz (2010) and Hellmann (1998) for venture capital markets and by Arrunada,

Garicano, and Vazquez(2001) for the auto industr y.

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