Intrafirm Trade, Pay-Performance Sensitivity and Organizational Structure

We study a model of a decentralized firm with moral hazard and intrafirm trade. Relationship-specific investments, by making internal trade more profitable at the margin, result in greater expected trade volume and thereby greater compensation risk borne by division managers. Formally accounting for this investment/risk link overturns some key findings in prior incomplete contracting studies. First, managers facing high-powered pay-performance sensitivity (PPS) invest less in relationship-specific assets. Hence, the optimal PPS will have to trade off investment and effort incentives. Second, incomplete contracting may result in overinvestment if the benefits from intrafirm trade are highly volatile, because the investing manager internalizes only a portion of the incremental trade-related risk premium. Third, the model can shed new light on the perennial question of organizing business units as investment or profit centers. Specifically, we derive conditions under which both divisions involved in intrafirm trade should be organized as investment centers, each choosing its own investment, and conditions under which one division should be in charge of choosing all investments while the other division is “downgraded” to profit center status without any investment authority.