ECON 3123, Week 12

Hongyi Li
October 2016

Hierarchies as Decentralized Information Processors

This section introduces another view on hierarchies. Here, we will think of hierarchies as a
method for decentralizing information processing.
Think of an organization as a place when a bunch of information from various sources is
collected and processed to make a decision.
For example, a firm may make capital allocation decisions by collecting financial information from the various divisions and using it to calculate the optimal allocation of
capital.
One very simple way to model the idea of collecting and processing multiple pieces of information is to think of the addition of 4 numbers, a1 + a2 + a3 + a4 .
Adding n numbers requires 3 addition operations:
a1 + a2

(1)

+ a3

(2)

+ a4 .

(3)

From arithmetic class, we know that the order in which addition takes place doesnt
matter: we could calculate (((a1 + a2 ) + a3 ) + a4 ) or (a1 + (a2 + (a3 + a4 ))) or ((a1 +
a2 ) + (a3 + a4 )) and get the same result each time. The main thing is that three addition
operations have to be performed.
Now, suppose that an individual is tasked to add four numbers together, and he can only
perform one addition per day. How long would he take to complete the task?
Three days, of course.
Now, if delays are costly, this might not be ideal; perhaps, decisions have to be made quickly
and delayed decisions result in reduced profits. Is there a way to speed up information
processing?
Yes. Consider the following setup:
There are three agents, x, y, z. Each takes one day to complete an addition operation.
x is in charge of adding a1 and a2
1

 y is in charge of adding a3 and a4 .

z is in charge of adding together the output that x obtains (a1 + a2 ) and the output that
y obtains (a3 + a4 ).
How long will this team take to complete the addition task?
Two days.
On the first day, x and y perform their additions.
On the second day, after x and y have produced their output, z performs his addition.
The key is that such a procedure allows for information processing to take place in
parallel : x and y can perform their operations at the same time, whereas in a singleagent setup, the single agent would have to perform in addition in sequence.
We may think of such a setup as corresponding to a two-layer hierarchy with x and y at the
bottom and z at the top: information is then processed starting from the bottom and passed
upwards.
We have shown how a simple two-layer hierarchy can reduce delay in a relatively simple task.
In fact, as the information processing task becomes more complicated, then more complex
hierarchies can be used to reduce delay even further.
For example, consider a task that requires the addition of eight numbers, a1 + a2 + ... + a8 .
Such a task involves seven addition operations.
In the hands of a single agent, the delay would be seven days.
However, a three-layer hierarchy with four agents in the bottom, two agents in the
middle, and one agent at the top would be able to complete the task in three days.
More generally, a task that requires the addition of 2n numbers can be completed in n days
with a n-layer hierarchy where there are 2k1 agents in the k-th topmost layer.
One natural question to ask is: what are the tradeoffs involved in the optimal hierarchical
structure? i.e. is adding layers to the organizational hierarchy can reduce delay, why not
always set up the organization to have as many layers as possible?
The first point to make is that there are limits to the ability of hierarchies to reduce delay.
Consider the first example: that of adding four numbers. As long as each addition operation takes one day, there is no way to reduce delay below two days. Thuse adding more
than two layers to the hierarchy does not improve the speed of information processing.
More generally, the optimal number of layers (that minimizes delay) is (weakly) decreasing in the number of addition operations involved in the task; but increasing the number
of layers beyond that does not speed things up further.
The second point to make is that more complicated hierarchies are more costly to maintain.
Consider an organization that receives one task to perform every three days; each task
consists of adding four numbers together. Each additional day of delay, per problem,
results in a cost of c being incurred.
2

 The organization has to pay each agent within the organization w in wages per day.
Consider the two alternative organizational structures that we introduced in the first
example: (i) a one-agent structure, versus (ii) a two-layer hierarchy with three agents.
Structure (i) results in a net payoff to the organization of w c per day. (The
one agent incurs a total daily wage of w, and each task is delayed for three days,
resulting in a per-day delay cost of 3c/3 = c.)
Structure (ii) results in a net payoff to the organization of 3w 2c
3 per day. (The
three agents incur a total daily wage of 3w, and each task is delayed for two days,
resulting in a per-day delay cost of 2c/3 = c.)
So, a one-layer hierarchy with a single agent is preferred to a two-layer, threeagent hierarchy whenever w is sufficiently large compared to c (specifically, whenever
2w > 3c ).
The take-away point here is that large hierarchies may reduce delay, but are more costly
to maintain. Consequently, organizations with less information-processing demands may
optimally choose to maintain less complicated hierarchies and tolerate some additional
delay.

Vertical Specialization in Hierarchies

This section presents yet another view of organizational hierarchies. Here, we will view
organizations as places where problems are encountered and solved, and hierarchies as a way
to organize the knowledge and skills necessary for solving problems. There are two basic ideas
here:
1. There are gains to specialization in knowledge. Knowledge acquisition is costly, so it may
be better to have each agent in an organization acquire a narrow subset of knowledge and
deal only with those problems that can be solved using that subset of knowledge, than
to have each agent try to be a jack-of-all-trades who can tackle all sorts of problems.
2. When individuals specialize their knowledge, a need to communicate will arise. Suppose
an agent has a problem that he cannot solve because he doesnt have the necessary
knowledge. Then he will have to pass the problem on to an agent who does know how
to solve the problem; passing on may involve communication costs (i.e. it takes time
and effort to explain the problem to someone else).
Well write down a simple model that captures these ideas, and well show how hierarchies
are useful in organizing problem-solving activities.
The key here is that hierarchical problem-solving corresponds to management by exception;
people at the bottom of the hierarchy learn how to solve the easiest problems, and pass on
those problems that they dont know how to solve to upper management, who learn how to
solve more advanced problems.

2.1

A Model of Vertical Knowledge Specialization

Consider an organization with N production workers. (Assume that N is fixed.)

Each production worker draws a unit measure of problems.
We can think of a unit measure of problems as essentially a large number of little
problems that occur with varying frequencies, so that the total probability adds up to
one.
Problems are indexed by their type, 0 x 1. High-x problems occur less frequently;
specifically, the distribution of problems follows a probability distribution f (x), with f 0 (x) <
0.
Each worker can choose which types of problems he learns how to solve. We say that a
worker has knowledge level z if he learns how to solve all problems of type x < z. Learning
more problems is more costly: learning how to solve all problems with x < z (i.e. acquiring
knowledge level z) requires a learning cost cz where c captures the cost of learning.
We may think of c as a function of the availability of information technology; an improvement in available information technology would make it cheaper to acquire knowledge,
and thus result in a decrease in c.
However, it is quite inefficient for every single production worker to independently acquire all
the necessary knowledge for solving all problems. In particular, the following arrangement
4

may be more efficient: each worker learns to solve a subset of all problems, and whenever he
encounters a problem that he cannot solve, he can pass the problem on to another agent who
has learned how to solve some of the problems that the production worker doesnt know. We
may think of this agent as a manager.
However, communication is time-consuming, in the following way. Each manager starts with a
unit measure of time. Listening to the production worker describe a fraction u of the workers
unit measure of problems takes up fraction uh of the managers time.
The advantage of such an arrangement is that it economizes on learning: if a manager helps multiple production workers, then the production workers do not have to
independently learn the problems that the manager specializes in solving; instead, only
one individual (the manager) has to learn how to solve those problems. This saves on
learning costs.
We may think of h as a function of the availability of communication technology; an
improvement in available communication technology would result in a decrease in h.
We may think of such an arrangement as a hierarchy, with managers at the top and production
workers at the bottom.
In particular, we are interested in the optimal hierarchical shape, i.e. the optimal ratio of
managers to production workers.
Let m be the number of managers. This would mean that for each manager, there
are N/m production workers assigned to that manager. That is, whenever each of
the production workers encounters a problem he cannot solve, he will pass it on to his
manager to solve.
We call N/m the span of control associated with the hierarchy. Were interested in the
determinants of the optimal span of control.
Before we go on, an important point to note: it is always optimal (from the point of view of
maximizing the organizations profits) for the workers to learn the most common problems,
i.e. each worker learns all problems of type x below some threshold x
. The reason is that,
by learning the most common problems, production workers avoid having to pass on tthese
frequently encountered problems to their managers, and thus to economize on communication
costs.
Consider an organization with N production workers and m managers, where every production worker learns the z most common problems, i.e. every problem with x < z. We assume
that each manager must learn how to solve every problem, i.e. zm = 1 (remember that the
hardest problem has type x = 1), so that all problems end up being solved (either by a
production worker or by his manager). Finally, suppose that each worker (both production
workers and managaers are paid a wage w.
We may think of z as the degree of autonomy or decentralization within the organization.
An organization with high z is one where each production worker has a lot of autonomy,
i.e., each worker solves most problems on his own without having to rely on his manager.

 The net profit of such an organization is

= N N (cz + w) m(czm + w).

(4)

Were interested in choosing m and z to maximize net profit (all other parameters are fixed.)
Notice that we are ignoring all incentive conflicts within the organization.
To solve this problem, note that
Each managers span of control is limited by the time he spends communicating. Remember that given the fraction z of problems that each worker learns how to solve, he
will have to communicate the remaining problems to the manager, which then takes up
h(1F (z)) of the managers time. Given that each manager has N/m subordinates (and
must spend h(1 F (z)) of his time on each), it must be that N
m h(1 F (z)) 1. So, to
minimize the wages paid and learning costs for managers, we minimize the number of
managers required (for given z) by choosing m = N h(1 F (z)).
Thus the organizations profit function becomes (remember that zm = 1)
= N N (cz + w) N h(1 F (z)(c + w)

(5)

= N (1 (cz + w) h(1 F (z)(c + w)).

(6)

The organization thus chooses z to maximize this expression, i.e. the optimal value of z
is such that the first-order condition is satisfied:

(N (1 (cz + w) h(1 F (z)(c + w))) = 0,

z

(7)

c = hf (z )(c + w).

(8)

i.e.
We wont directly obtain an expression for the optimal value of z, which we denote as z .
However, well look at how z depends on the other parameters.
2

0
Before diving in, notice that z
2 = h(c + w)f (z) < 0, which ensures that the first-order
approach is valid (i.e. the first-order condition gives us a maximum profit).

First, lets look at how z depends on c (the cost of learning). We calculate

following identity:

dz
2 /cz 
= 2
.
dc
/z 2 z=z

dz
dc

using the

(9)

We already know that the denominator of this expression is negative. The numerator is also
c
easy to sign: 2 /cz|z=z = N (c + hf (z )) = N (1 + c+w
) < 0. (Here we use the fact,

following from the first-order condition, that hf (z ) = c+w .) This implies that dz
dc < 0.
This suggests that an improvement in information technology (a decrease in c) will
increase worker autonomy. The intuition is this. An increase in worker autonomy has
two effects, one positive and one negative: (i) an increased cost of learning, versus
6

(ii) a reduction in communication cost because less problems need to be referred to

the manager. Improvements in information technology mean that (i) becomes less of
a factor; consequently, the tradeoff shifts in favor of more autonomy, and the optimal
degree of worker autonomy decreases.
We may also ask: how does an improvement in information technology affect the optimal
number of managers, m = N h(1 F (z ))? The answer is that m decreases in z and
thus increases in c: by increasing the amount of time that the manager has to spend on
each worker (because the worker is now more autonomous and solves more problesm on
his own), improvement in information technology results in an increased span of control.
Second, lets look at how z depends on h (the difficulty of communication). We calculate
dz
dh using the following identity:
2 /hz
dz
= 2
.
dh
/z 2

(10)

We already know that the denominator of this expression is negative. The numerator is also

easy to sign: 2 /hz = f (z)(c + w) > 0. This implies that dz

dh > 0.
This suggests that an improvement in communication technology (a decrease in h) will
reduce worker autonomy. The intuition is this. Recall that an increase in worker autonomy has two effects: (i) an increased cost of learning, versus (ii) a reduction in communication cost because less problems need to be referred to the manager. Improvements
in communication technology mean that (ii) becomes less of a factor; consequently, the
tradeoff shifts in favor of less autonomy, and the optimal degree of worker autonomy
decreases.
We may also ask: how does an improvement in communication technology affect the
optimal span of control, m = N h(1 F (z ))? The answer is ambiguous. On the one
hand, improvements in communication technology result in the principal being able to
handle more problems. On the other hand, it results in a reduction in worker autonomy,
and thus an increase in the time spent by the manager on each worker.