Performance Measurement, Compensation Schemes,and the Allocation of Interdependence Effects

In practice, firms often exhibit divisionalized structures in which headquarters delegate decision rights to divisional managers. In this paper, we examine the problem of allocating interdependence effects stemming from interdivisional trade. For this, we analyze a model in which a divisionalized firm contracts with two managers to operate their divisions and to make relationship-specific investment decisions. Contracts can be based on both divisional profits and hence depend on the allocation of interdependence effects. In line with transfer pricing literature, we discuss a centralized as well as a decentralized setting with respect to the allocation authority. Issues of mechanism design concerning divisional trade are extensively discussed in the literature. Most related to our paper is [1] which shows that profit sharing induces managers to make first-best investment decisions in a decentralized setting. However, profit sharing imposes extra risk on the managers and therefore may not be optimal. Our paper extends the analysis of [1] by incorporating moral hazard problems with respect to investment decisions. Further, we distinguish between different organizational designs.