Why are Firms Hierarchical?

Abstract

Firms are hierarchical because hierarchy facilitates both monitoring and control. Monitoring is readily explained in terms of agency costs, but control is not. Control relations between superiors and subordinates emerge naturally only when the superior has decisive information and the subordinate does not. When decisiveness does not naturally occur, it may nevertheless be imposed in order to reduce communication costs. The degree of decisiveness reflects the pattern of volatility in the firm's environment. The theory connects the volatility of the environment to the degree of hierarchy in the organisation. Recent changes in volatility can be used to explain contemporary demands for flatter organizational structures.

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