David P. Baron and David Besanko
This paper investigates how a designer of an organization (referred to as the regulator) should organize a production activity in which two different units produce components and where each unit has private information about its costs. Three organizational structures are analyzed. In the first (informational consolidation), the regulator contracts with a consolidated unit that produces both components. In the second (informational decentralization), the regulator independently contracts with the producer of each component. In the third (informational delegation), the regulator contracts with one of the units, which in turn subcontracts with the other. In each case, the regulator’s optimal mechanism consisting of payment and output schedules is fully characterized. Informational consolidation and informational decentralization yield different output schedules. Under informational decentralization, the optimal output schedule may not depend on the sum of the marginal costs of each component, but when it does, the regulator strictly prefers informational consolidation to informational decentralization. Informational delegation is shown to be equivalent to informational decentralization when the regulator can observe the contracting between the units.