Organizational Design and Environmental Volatility

I investigate the link between the volatility of a …rm’s operating environment and its preferred organizational structure, as determined by the allocation of decision rights, the compensation structure of the managers and the degree of operational integration. The results are broadly consistent with the common wisdom regarding the …t between organizational design and the environment. Volatile environments are populated by organizations that have loosely coupled operations to maintain local responsiveness, together with decentralized decision-making and pay that is tied primarily to divisional performance. Stable environments, on the other hand, are populated by organizations that have tightly integrated operations to realize cost savings, together with (typically) centralized decision-making and pay that is closely tied to …rm-level performance. The results also re…ne these relationships. For example, while decentralization and volatility are positively associated in equilibrium, volatility is not directly causing decentralization. Instead, decentralization arises only as a part of the overall adjustment in organizational design and simply decentralizing decision-making as a response to an increase in volatility would actually worsen organizational performance. JEL Classi…cations: D2, D8, L2 Contact: [email protected]. This paper is a heavily revised version of Chapter 2 of my Ph.D. Dissertation. I would like to thank my advisors Robert Gibbons and Bengt Holmström for many helpful discussions and continuous encouragement. The paper has also bene…ted from comments by Tony Marino, Ricardo Alonso, the participants of ESSET2008, ESAM08, 2007 SITE Summer Workshop, and the seminar participants at various universities. All remaining errors are my own.