Working Paper Series Working Paper No.

01-5 August 2001

DECISION PROCESSES, AGENCY PROBLEMS, AND INFORMATION: AN ECONOMIC ANALYSIS OF BUDGET PROCEDURES

Anthony M. Marino and John G. Matsusaka

This paper can be downloaded without charge at: The FBE Working Paper Series Index: http://www.marshall.usc.edu/web/FBE.cfm?doc_id=1491 Social Science Research Network Electronic Paper Collection: http://papers.ssrn.com/abstract_id=239252

Decision Processes, Agency Problems, and Information: An Economic Analysis of Budget Procedures

Anthony M. Marino and John G. Matsusaka University of Southern California

Many organizations attempt to manage agency problems not with incentive contracts but by keeping the principal involved in the decision process, that is, by limiting delegation. This paper develops a model to investigate the economics of several decision processes that are commonly used to set budgets in both the public and private s ector. The key tradeoff is that partial delegation allows the principal to reject those projects he dislikes, but causes the agent to distort the information he transmits to the principal.

August 2001

Comments are appreciated. We thank Tom Gilligan, Randall Kroszner, Fulvio Ortu, and Jan Zabojnik for helpful discussions and workshop participants at Cornell University, Hong Kong UST, MIT, University of Chicago, University of Hong Kong, University of Kansas, and USC for constructive feedback. Research support was provided by the Earhart Foundation, USC, and the Stigler Center at the University of Chicago. contact the authors at amarino@marshall.usc.edu and Please

matsusak@rcf.usc.edu or

Department of Finance and Business Economics, Marshall School of Business, University of Southern California, Los Angeles, CA 90089-1427. Updates will be posted on http://www-rcf.usc.edu/~amarino.

I.

Introduction

Managing principal-agent problems is a perennial challenge for organizations in both the public and private sector. A common strategy is to structure the decisionmaking process so that the principal retains some authority or to otherwise limit the amount of delegation. Consider, for example, the different ways school districts set their budgets. While complete delegation is most familiar—the principals (voters) leave the spending decisions entirely to their agents (school board)—some school districts (in Oregon, New York, and other states) employ referendums: the school board’s budget proposal must be approved by the voters to go into effect. Other school districts allows voters to approve the board’s spending plan in a modified form, or set the budget independent of the board using voter initiatives. Also, in some school districts, the board’s budget proposal is subject to ex ante caps on total expenditure or total taxes (California).1 Similar variation appears in corporations, or what might be more familiar to some readers, universities. Here the principal is the CEO (dean) and the agent is a division manager (department chair). Hiring decisions of staff (and junior faculty) are fully delegated typically, while decisions concerning executives (senior faculty) are subject to veto. Expenditures of a routine nature are delegated, while expenditures for new

1

Swiss cantons, which are analogous to American states, display an equally wide variation in decision

processes including complete delegation, mandatory referendums on new projects above a spending threshold, initiatives, and town meetings (Feld and Matsusaka, 2000). For an extensive discussion of various institutional processes employed by the U.S. Congress to contain delegation problems, see Kiewiet and McCubbins (1991).

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products, plants, and facilities are subject to veto. The trend in some universities toward faculty-controlled expense accounts is a move toward delegation, and away from a situation where travel expenditures, computers, and the like required approval. The rich variety of decision processes observed in practice poses important research questions. What explains why different organizations adopt different decision processes and why different procedures are used within a given organization? And how do the actual decisions that emerge depend on the procedure used to make them? Existing theory provides only fragmentary guidance on these questions. Our goal in this paper is to develop a model of the budgeting process that will fill in part of the picture. We are especially interested in shedding some light on the tradeoffs between decision processes that are actually observed in practice. Our analysis turns on the superior information of the agent, which presumably is one reason the agency relationship is established in the first place. If the principal is worried that the agent might do the wrong thing, at first glance it would seem to be always in the principal’s interest to retain the right to intervene in the decision. In the worst case where the principal is completely uninformed, he can always rubber-stamp the agent’s proposal. The question then boils down to, what is the cost of retaining a right to intervene? One potential cost was emphasized recently by Aghion and Tirole (1997): if the agent can be overruled, he might inefficiently reduce his information-collection effort. We focus on a problem that has received less attention: the agent may distort the information he transmits to the principal if he fears being overruled.2

2

Another distortion can arise at the implementation stage: Zabojnik (forthcoming) explores inefficiencies

that may occur when the agent is forced to implement a project that he particularly dislikes.

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An agent with a low quality project. With this intuition in mind. When the principal cannot separate good from bad proposals. The reason is that it is less costly for the agent to mimic a project that is just “a little” better than his project. in what situations do the benefits of delegation exceed the costs? A key result is that the principal prefers to delegate in situations where an agent with a low quality project would mimic an agent with a high quality project (that is. The budget process begins with the agent proposing a spending plan. We assume the agent derives private benefits from spending and is therefore more willing to go forward with a project than the principal is. a pooling equilibrium). First. The desirability of delegation then depends on whether or not pooling occurs. Several implications follow: (1) Delegation is optimal for projects with low variance (“routine”) while veto is better for those with high variance (“innovative”). the principal has the right to reject it. the principal can be worse off with a veto because projects become inefficiently large. the proposal goes into effect immediately. One implication is that spending actually can be higher under a veto process than under delegation. then. Since the agent has superior information. than one that is 3 . may propose an excessively large budget in order gain the principal’s approval.The essential tradeoff can be seen by comparing full delegation with a decision process in which the principal retains a veto right. The principal prefers to retain veto rights when mimicking does not occur (a separating equilibrium). we explore several issues. while under the veto process. the principal will view a large spending proposal as indicative of a high quality project. If it is optimal to invest more in high quality projects. the principal will attempt to infer something about the project’s quality from the agent’s spending proposal. Under full delegation.

It is possible for a worsening of the agency problem to make pooling less likely because it requires a larger proposal to successfully pool. Therefore. (3) The information distortion problems at the center of our analysis are less important when the agent’s information can be verified by an outsider. A third variant provides complete delegation for spending below a given amount and veto otherwise. Here again. This process can deliver the principal’s unconstrained optimal outcome in some circumstances. This can happen if the spending threshold makes it easier for an agent with a low quality project to pool. In our model. an agent with a low quality project may have an incentive to propose a large project in order to pool and avoid being overridden by the principal. In our model. and can be counterproductive (increase spending) when coupled with a veto process.” Second. such a restriction always reduces spending when the decision is delegated. not because it helps the principal avoid time costs of trivial 4 . but can increase spending when the principal retains veto rights. but is dominated by veto and delegation in others. the model suggests that delegation is better when the agent’s information is “soft” than when it is “hard. (2) Delegation does not necessarily become better as the agent’s preferences move into alignment with the principal’s preferences. we explore variants of the two basic budgeting processes. such an arrangement is generally superior to pure delegation or pure veto. An implication is that spending limits are more effective when coupled with delegated decisionmaking. Another variant allows the principal to approve the proposal in a modified form rather than accept or reject it as is.“much” better. One variant is to set an upper bound on the amount of spending ex ante.

and if so. We provide one answer to this by characterizing the optimal decision process/mechanism using the revelation principle. an uninformed agent may make too aggressive a proposal. it is also interesting to identify what an optimal budget process would be in our model environment.3 We follow that path by focusing on actual decision processes. 1989. essentially relying on the principal to identify project flaws that he did not see. Aghion and Tirole (1997) develop a model to study the tradeoffs between complete delegation and complete non-delegation. but expand the scope to consider delegation and other processes that are employed outside of legislatures. Although the main purpose of our paper is to identify tradeoffs between existing budget processes. Our paper is related to several others in the literature. This can create a pooling situation. 1990) that studied the tradeoff between open and closed rules in parliaments. the principal may find delegation more desirable when he is informed. This is not necessarily true in our model. 3 See Gilligan (1993) for a survey and more complete list of articles. We also explore an alternative information structure—what happens if the principal is also informed about the project’s quality? Casual intuition suggests that delegation becomes less desirable if the principal is informed. When the principal is informed. but because it reduces the likelihood of pooling by allowing an agent with a low quality project to separate. 5 . Delegation is the exception— it can never be an optimal mechanism. The pioneering work in the area is the series of papers by Gilligan and Krehbiel (1987.matters. It turns out that the actual decision processes we study can be viewed as optimal mechanisms for some parameter configurations. or as very close approximations.

4 Their approaches are complementary to ours (especially where we consider optimal mechanisms) but the emphasis is different. we study the effect on information transmission.While they focus on how limiting delegation can affect the agent’s information collection efforts. Cai. We also incorporate institutional details of actual decision processes. Harris and Raviv (1996. Section IV investigates three variants of the basic decision processes: spending limits. delegation and veto. Section II describes the model. Section III develops the tradeoff between two simple decision processes. Section V extends the model to consider an informed principal. Section VI compares our approach to a mechanism design approach. Section VII concludes. and Luo (2000) that considers the interaction between incentive contracts and budgeting procedures. We are primarily interested in understanding the consequences of observed budgeting practices (that may or may not be optimal) and not as much in identifying the globally optimal practice. override. respectively. and threshold delegation. 6 . The paper is organized as follows. in corporate and legislative environments. 4 See also the recent paper by Bernardo. 1998) and Baron (2000) study the properties of optimal decision processes using a mechanism design approach.

the agent possibly receives information about a project’s value. B. The principal provides the funding for the investment. In period 0. H} indicate the agent’s information where M indicates no information. a new school building) is θ ∈ {H. A. 7 . and the agent is the school board. M. The agent has private information: with probability p he knows the project’s quality. the principal can reject the proposal (unless the decision is fully delegated). Information The underlying “quality” of the project (say. Sequence of Actions There are three periods. Let I ∈ {L. and E[θ ] ≡ M .II. In period 2. At this point we assume that the principal is uninformed: he knows only the distribution of θ. think of a school board deciding whether to construct a new school building. L} with probabilities π and 1 – π respectively. The principal is the taxpayer who will ultimately provide the funds for the building. and proposes a level of funding. the principal adopts a decision process. the investment is made and the project pays off. The Model The model features a principal who employs an agent to evaluate projects and make proposals. where H > L. We consider the case of an informed principal below. and if approved. In period 1. An alternative “corporate” interpretation is that the principal is a capital budgeting committee and the agent is a division manager. For concreteness. We can think of θ as parameterizing the expected enrollments over the life of a new building.

First. In a corporate context. Project Return A project’s gross return is θf (n ) . D. both of which are fairly standard in the literature. its members are not oblivious to the will of the voters. This payoff function could be a primitive. if the school board has to stand for re-election. For example. the agent cares about the principal’s utility. his utility function is (1) v = θf ( n ) − n. The utility function of the agent is assumed to be u = v + αn . n could represent the square feet of the building. but there are enough frictions in the voting market that incumbent officeholders can capture some rents. he also derives a payoff from project size per se. but second. Principal and Agent Utility Functions The principal and agent are risk neutral. This formulation has two important features. The principal provides the funds for the project at a (normalized) cost of 1 per unit.C. Since the principal pays the cost of the project. (2) where 0 ≤ α < 1. or it could be induced by external sanctions. (2) could be treated as the reduced form of a model in which 8 . In our school board example. where n is the scale of the project and f is increasing and concave with f (0) = 0 .

It is necessary below to calculate principal and agent expected utilities conditional on beliefs about the value of θ. The agent’s opportunity cost of a unit of n is 1 − α and the principal’s cost is 1. We will express these expected utilities as uI and v I where I is an actor’s expected value of θ conditional on his information. A comparison of (2) and (3) indicates that the principal and agent in our formulation differ only in their private opportunity cost of funds. When the agent has no information. max n u M > 0. The consequence of this specification is that the agent prefers a larger n than the principal does. we assume they may disagree about whether a project is worth funding. Agent’s utility function: u L < 0 for all n. Both would like to go forward (at least for some n) if the project is known to be high quality and neither wants the project if it is low quality. other things equal. The formal statement of these assumptions is this: Assumptions. uH is the agent’s utility conditional on knowing the quality of the project is H. They disagree when there is no information (I = M): The agent would like to proceed but principal would like to stop.equilibrium contracts do not perfectly align principal and agent incentives. max n u H > 0 . v M < 0 for all n. 9 . his utility is uM. For example. We shall sometimes refer to α as the severity of the agency problem. The agent’s utility function can be restated as (3) u = θf ( n) − (1 − α)n. To create an interesting conflict between the principal and agent. max n v H > 0 . Principal’s utility function: v L < 0 for all n.

III. but always the result of the review was ‘go’ or ‘no go.5 Both processes are common in practice.’ The definition of a project did not change.7 processes. Bower’s (1970) well known study of capital budgeting practices characterizes one (allegedly 6 7 representative) company as follows (page 65): “The (executive committee) review varied in thoroughness depending in large measure on the extent of the project’s controversialism.” The interesting feature here is that executive committee did not modify proposals. and Munley. The parliamentary closed rule is another example (Gilligan and Krehbiel. Rosenthal. in many school districts the school board’s budget proposal does not go into effect if a majority of the voters reject it (see Romer. The public sector version of veto is a mandatory referendum. Most states require referendums for debt issues (Bohn and Inman. 1996) and most Swiss cantons require referendums for new public expenditures (Feld and Matsusaka. we will consider other and more complicated decision 5 Our depiction of the veto process follows Romer and Rosenthal (1979) as extended by Banks (1990).6 Something like a veto process appears in corporate budgeting as well. 1987). 1992). Later. The second is veto: the agent proposes a scale and the principal can either approve it without modification or reject it completely. 2000). The first is (complete) delegation: the agent is given the power to approve the project at whatever scale he chooses and cannot be overruled by the principal. For example. Two Simple Decision Processes: Delegation and Veto We highlight the basic tradeoffs by comparing two simple decision processes. 10 .

The optimal scale is increasing in I. the optimal scale solves If ′( n * I ) = 1 − α. When nonzero. the M-agent may pool with the Hagent. Veto Under the veto process. Complete Delegation Under complete delegation. that is. expected utility under complete delegation (D) is then (4) E0 [ v | D ] = (1 − p ) v M ( n * v H (n * M ) + pπ H ). we assume that 11 . he may propose the scale that an H-agent would have chosen. I. By assumption. The first term is less than zero. the project goes forward at the agent’s optimal spending level. A number of different outcomes are possible depending on the parameter configurations.A. n * The principal’s (period 0) L =0. Therefore. We assume that v H ( n * H ) > 0 so that the principal’s expected utility from delegation is not trivially negative. He will do so if he infers from the proposal that the agent has no information. but the interesting economics can be seen by comparing equilibria in which agent proposals pool with those in which they separate. Let n * be the optimal scale for the agent (the maximand of (3)) I conditional on his information. the principal can reject the proposal. The most transparent cases attain when the principal is willing to accept the H-agent’s optimal project size conditional on knowing that the agent has I ∈ {M . H } . In particular. B. The uninformed agent (“Magent”) takes this into account when making his proposal.

8 8 This is the only equilibrium that survives the usual refinements. the H-agent and M-agent both propose n H . * Pooling equilibrium: When u M ( n * H ) > 0 . will not deviate. there are two (Perfect Bayesian) equilibria distinguished by one simple condition.v R (n * H + (1 − p)(1 − π ) L) /(1 − p + pπ ) is the expected project value H ) > 0 . but zero if he deviates because his proposal will be rejected. where R = (π conditional on I ≠ L . the principal’s behavior is optimal along the equilibrium path because v R ( n * H ) > 0 . the H-agent. beliefs that give such a large weight to M are eliminated by the standard refinements. Obviously. which is the only reasonable conjecture. * * * * * 12 . The M-agent’s payoff is positive in equilibrium. and his rejection of proposals off the equilibrium path is optimal if he believes those deviations come from an M-agent. and rejects all others. the principal accepts a proposal of n * H . there is a Perfect Bayesian equilibrium where the agents pool at n H − δ . The proof is straightforward. since only the H-agent would like to deviate to n H . such as the intuitive criterion and D1. For the principal to find it optimal to reject a deviation of n H . For example. and rejects all other proposals. Given this. However. the principal accepts this proposal. This is an equilibrium because no agent type gains from making a different proposal. who is receiving his globally optimal outcome. Finally. and the principal cannot do better with an alternative adoption strategy. he must believe the agent’s conditional expected type is less than R (since v R (n H ) > 0 ). Equilibria that pool at n H + δ do not survive refinements for similar reasons.

The agent’s incentive to pad his proposal when the principal is involved in the decision drives the key tradeoffs in the model. you could have done a few less markets. We are unaware of systematic evidence that can tell us how often this happens. There was a unique opportunity to raise a huge amount of capital in the public market so we could build a business far faster than Sam Walton rolled out Wal-Mart.” Why didn’t Webvan start in a single market and incur only minor losses until it figured out how to operate in the black? According to a venture capitalist who backed Webvan.’ but there was a huge Catch-22. Customers went to the company’s web site to order groceries.com. get their model perfect and show they could have a positive cash flow. This is somewhat counterintuitive: the principal knows that the agent is excessively fond of spending. and make b ig promises to investors.” This 13 . and closed down and liquidated in July 2001. which were then home-delivered in the company’s signature bluegreen vans. Webvan lost approximately $100 million each month. ran out of cash. was that Webvan set out to enter 26 markets before it had figured out how to turn a profit in one: “They needed to operate in one market. “It’s easy to say. but the history of online grocer Webvan provides an interesting case study. The company raised $1. However. build a brand name. `Man.2 billion on the equity markets. No one has ever gone public with a national rollout with zero markets performing to plan. more than any online retailer except Amazon. according to analysts.The important feature of this equilibrium is that the agent may ask for a larger budget than he would like in an effort to mislead the principal about the project’s prospects. but the agent fears that his proposal will be rejected if it is too small. Webvan opened for business in July 1999. you had to get above the noise level. But to raise money. The problem.

” New York Times. there are two possible equilibria. 2001. February 19. the H-agent proposes n * H . and rejects all other proposals. Then the principal’s expected return is E0 [ v | V ] = pπv H (n * H ). In equilibrium the project goes forward only if the agent knows that I = H. except that here the M-agent would rather not have the project at all than operate it at the H-agent’s preferred scale. and the second is from David Beirne with Benchmark Capital. The principal’s expected payoff under veto ( V) in this equilibrium is then (5) E0 [ v | V ] = (1 − p) v M ( n * v H ( n* H ) + pπ H ). and which one attains depends on whether the uninformed agent earns a positive return from mimicking the H-agent’s 9 The first quote is from Lauren Levitan. (6) To summarize. the M-agent * proposes n ≠ n * H . 14 . the project goes forward at a scale of n * if the agent’s H information is M or H. 9 In equilibrium. Both were taken from “ Some Hard Lessons for Online Grocer. an analyst with Robertson Stephens. * Separating equilibrium: When u M ( nH ) < 0 . The proof is identical to the one above.is exactly the sort of behavior our model tries to capture: Webvan’s backers felt they needed to propose a bigger project than they really wanted in order to attract funding. the principal accepts a proposal of n H .

Proposition 1. since it can be exercised at no opportunity cost.proposal. In our school board example. The principal chooses a decision process in period 0. Gibbons. then there are both pooling and separating equilibria. as discussed by Baker. This turns out not to be true in some situations. see the continuous models of Crawford and Sobel (1982) and Banks (1990). the referendum is provided by the state legislature or constitution. But reasonably effective commitment devices are often present. it is difficult to find an environment where the principal can unalterably commit to a decision process since some sort of escape route is usually available. 10 The possibility of both pooling and separating behavior here is a general feature of signaling games of this type. In practice. making it costly to add or remove. Commitment also can be supported by reputation or repeated play. * 15 . For example. and prefers veto when the veto equilibrium separates ( u M ( n H ) < 0 ). and Murphy (1999). C. For all practical purposes. Comparison of Delegation and Veto Now we compare the two decision processes from the principal’s point of view. The principal prefers delegation when the veto equilibrium pools * ( u M (n * H ) > 0 ). Casual intuition suggests that the principal would always prefer veto to delegation. 10 If u M ( n H ) = 0 . and does not depend on discreteness in our model or the particular parameter configurations we have assumed. and we assume that he can commit to it. whatever decision process is in place at the start of a budget cycle cannot be altered by the electorate until the next budget cycle at the earliest.

the cost is that agents will pad their proposals to make them appear more valuable. the project is implemented at a scale of n * M . The difference in decision processes appears in the M state. 11 Note that the agent’s utility also depends on the choice of decision process.The proof follows from comparison of (4). and increasingly so as n rises. n * H . In this state. Under delegation. the project also goes ahead. which is ideal for the principal. A conventional explanation for delegation is to economize on the principal’s time. In general. Whether delegation or veto is optimal depends on how willing the agent is to pad his proposal. We abstract from this issue by assuming that the agent’s participation constraint does not bind. Under veto with pooling. The intuition is this: Under both delegation a nd veto. but at an even larger scale. this could be relevant for the principal if it affects the wage paid to the agent. the principal’s payoff is negative for any n > 0 . Proposition 1 identifies another possible rationale for delegation. the project goes forward in the H state at scale n * H and does not go forward in the L state. and suggests that the principal may wish to delegate even if the opportunity cost of his time is small. and (6). under veto with separation. 16 . (5). the project does not go forward. In contrast.11 The basic tradeoff can be summarized as follows: the benefit of veto is that it allows the principal to reject some projects he dislikes. which is worse for the principal. See Aghion and Tirole (1997) for a model where the participation constraint plays an important role in the choice of a decision process.

Intuitively. veto becomes more appealing for the principal. When is Delegation Better than Veto? The next question is what determines whether delegation or veto is optimal for the principal? Proposition 1 indicates that the answer depends on whether the M-agent pools with the H-agent or separates under the veto process. (1) Since u M ( n * H ) does not depend on p.D. Several observations follow. an increase in H holding constant M makes it more costly for the M-agent to mimic the H-agent’s proposal. Changes in p are irrelevant only if they do not violate our parametric assumptions. although it will not change the sign of the difference. Casual intuition might suggest that full delegation is better when the agent is more likely to be informed. an immediate result is that the optimal decision process does not depend on the probability that the agent is informed.12 (2) Veto becomes better when H rises holding constant M. A large enough fall in u M ( n H ) makes veto optimal. Formally. This is not the case in our model because the optimality of delegation does not turn on the agent’s information—he knows the same amount regardless of the decision process—but on the likelihood of pooling. An increase in H causes n * H to * rise. and thereby u M ( n * H ) to fall. What this says. delegation is better when u M (n * H ) > 0 . particularly that v R (n H ) > 0 . 12 An increase in p will decrease the magnitude of the difference between the principal’s payoff under the two decision processes. is that as the project’s upside (or variance) increases. less formally. The reason is that it becomes less likely that an uninformed agent would choose to pool. * 17 .

which makes pooling less attractive for the M-agent. which can raise or lower ε depending on the precise form of f . and an increase in α has the opposite effect. Here. with the −n 2 restriction n < 0 . (4) The general sense of the model is that veto is problematic when it causes the agent to distort his proposal. ε is decreasing in n . (3) Casual intuition again suggests that as the agency problem becomes more severe. while veto is optimal for new and innovative projects. If f ( n ) = 1 − e increasing in n .This logic suggests that delegation might be better for routine tasks with little upside potential. The net effect depends on which of these two forces dominates. We expect this problem to be most severe in situations where the agent’s information is “soft” in the sense that it cannot be verified by anyone else. The bottom i lne is that there is not a simple connection between severity of the agency problem and the desirability of veto. with the restriction n < 1 . then ε is 18 .13 More intuitively. veto is a better choice. When information is “hard” the principal could set up an auditing processes that 13 One specification in which delegation becomes a better choice when α rises is f ( n ) = n − n . ε (n ) = nf ′( n) / f ( n) is the elasticity of f . but the rise in α also reduces the M-agent’s cost of n.5 . a rise in α increases n * H . An increase in α causes an increase in n * H. This is not necessarily true in our model: an increase in α can make delegation or veto optimal. note that the condition u M ( n * H ) > 0 can be restated using the definitions of uM and n* H as M / H > ε( n * where H ). To see why.

On the other hand.14 E. an extension of Romer and Rosenthal (1979)). veto does result in lower spending because the principal shuts down the project when the agent is uninformed. Proposition 2.might allow him to tap the agent’s information with less risk of distortion in the project. This would be true in a complete information model (for example. 14 This contrasts with the model of Aghion and Tirole (1997) in which the optimal decision process does not depend on whether information is hard or soft. Our model suggests that delegation is better for the principal when information is soft. a veto process results in less spending. Spending Level Another interesting question is how does the decision process affect the size of the project? Empirical evidence suggests that spending outcomes are different under full delegation and veto. (1) Casual reasoning suggests that when the agent is more inclined toward spending than the principal is.15 We can express project size/spending in terms of our model as E0 [n]. The expected value of spending is higher under delegation than under veto when the veto equilibrium separates. where veto has a pruning effect. and is lower when the veto equilibrium pools. The next proposition follows from simple calculation. and veto is better when information is hard. 19 . 15 See Matsusaka (1995. In the separating case. 2000) and Feld and Matsusaka (2000) for evidence and references to the literature. It is not necessarily true in our asymmetric information model.

and those projects acceptable to House as a whole are passed in an omnibus water project bill. which could make pooling more attractive to the M-agent. In 1986.in the pooling case. a fall in α reduces the H-agent’s proposal. A recent study of congressional water project proposals by DelRossi and Inman (1999) contains some pertinent evidence. the rules were changed so that local taxpayers had to contribute part of the funding. Intuitively. congressmen with pending proposals were allowed to modify their proposals in light of the new cost-sharing requirement. Water project proposals originate with individual congressmen who presumably see a benefit to their district from the project. Prior to 1986. 20 . a large enough fall in α can transform a separating equilibrium into a pooling equilibrium and therefore cause spending to rise. (3) An important feature of our depiction of the veto decision process is that proposals do not necessarily indicate the agent’s underlying demand. while after 1986 an additional cash contribution on the order of 25 percent of cost was required. However. (2) Under delegation. spending is higher under veto because the uninformed agent increases his proposal in order to pool with the H-agent. 16 When the rule change went into effect. a decline in α causes spending to fall. This is not necessarily true under veto. 16 To oversimplify. A decline in α does result in less spending holding constant the type of equilibrium (pooling or separating). the local government only had to contribute the land necessary for the project. prior to 1986. the funds for water projects were taken from general revenues.

think of Congress as the principal (source of funds) and the individual representative as the agent. However.17 DelRossi and Inman document that on average. 85 of 335 proposals were rejected from the omnibus bill. 21 . Since proposals appear 18 to have been strategic. Such behavior is inconsistent with a complete information (nonstrategic) view of the veto process. Prior to 1986. Therefore. but can arise naturally in our model. 30 of 82 sample projects were increased in size in the wake of the reform. the reform reduced α. the individual representative’s private cost of funds was approximately zero (that is. It is also inconsistent with the view that a complete delegation process was used.In terms of our model. but could reject it.25 ). The prevailing decision process was essentially veto—the Congress did not modify a member’s proposal. representatives responded to the reform by cutting back the size of their proposals.18 17 In the years studied by DelRossi and Inman. this calls into question DelRossi and Inman’s assumption that the proposal revealed the individual representative’s demand. This is what we expect if proposals reflect the agents’ demands. 1 − α ≈ 0 ) while after 1986 it was positive ( 1 − α ≈ 0.

a * spending limit in excess of n * H does not bind. It is clear that N > n * H would have no effect. A spending limit set below n H reduces the project size in the pooling equilibrium. This makes the principal better off. this might take the form of a restriction on spending growth based on a formula that incorporates enrollments and inflation. at least until N reaches the principal’s optimal spending level in the H state. a statutory maximum property tax rate. or less directly. 22 . In this case. Reductions in N below this point will continue to cut spending. As above. in the separating equilibrium. N. This can happen if the spending limit reduces the H-agent’s proposal to the point where the M-agent becomes willing to mimic it. We can model a spending limit as an upper bound. As N falls below n * H . the spending limit cuts the size of the H-agent’s project. However. Consider a spending limit with delegation first. delegation becomes more desirable than veto for the principal. if it transforms a separating equilibrium into a pooling equilibrium. a spending limit below n * H may increase the expected project size. Variants of the Simple Decision Processes A.IV. Now consider a spending limit in the context of the veto process. on the project size that is set in period 0 and cannot be altered thereafter. In our school board example. that is. although this benefits the principal only if the gains from reducing the Magent’s proposal (if any) exceed the losses from reducing the H-agent’s proposal. Ex Ante Spending Limit A popular variant of the delegation and veto decision processes is to limit the total amount of spending ex ante.

and does not have the option to adopt the proposal in a modified form. delegation is always (weakly) optimal. we would expect to see spending limits more often in situations where delegation is used than those where veto is used. Override In the veto decision process. a spending limit makes it harder for him to separate from the M-agent. In practice. the principal commits to approve or reject the agent’s proposal. This leads to the next proposition. B. they may be substitutes. somewhat counterintuitively.Intuitively. Here we examine a decision process called override in which the principal is 23 . Rather. Another empirical implication is that spending limits are more effective (cut spending by a larger amount) when used in conjunction with a delegation process than when used with a veto process. One thing Proposition 3 suggests. (a) A binding spending limit reduces spending under delegation but can increase spending under veto. then. Proposition 3. by constraining the H-agent. in other situations the principal retains the right to substitute his own proposal for the agent’s proposal. While this is a reasonable description of the referendum and parliamentary closed rule. (b) For a sufficiently low spending limit. is that a spending limit and the veto process might not be complementary ways to address an agency problem.

interesting equilibria depend on whether the M-agent pools or separates. the agent’s actual proposal is formally irrelevant. The M-agent faces a choice: if he reports truthfully. the principal’s optimal scale conditional on I ∈ { M . accept it “as is”. define n H H ) = 1 ). We use one asterisk to indicate the agent’s optimal spending levels. 19 This is the non-delegation decision process studied in Aghion and Tirole (1997). the solution to * ** * 20 R f ′( n * as the solution to Hf ′( n * As with veto. 24 . All that matters is the agent’s report to the principal of the state. M. and two asterisks to indicate the 20 principal’s optimal spending levels. or approve the project at a scale of his own choosing. The Hagent also reports truthfully because he has nothing to gain by pretending to be an Lagent or M-agent. while if he lies and reports H then the project will be implemented at * n* R . the R ) = 1 (similarly. Our earlier ** assumption that v R ( n * H ) > 0 implies that v R ( n R ) > 0 . which narrows the field to two equilibria.free to reject the agent’s proposal. or H. L. that is. the H -agent and M-agent both report H.19 Under the override decision process. and approves the project at a * scale of n * R if the agent reports H. The L-agent reports truthfully and the principal does not proceed with the project. the principal rejects the project if the agent reports L or M. then the project will be rejected. ** Pooling equilibrium: When u M ( nR ) > 0 . H } .

and the principal * rejects the project if the agent reports L or M. Proposition 4. and approves the project at a scale of n * H if the agent reports H. that is. it is not difficult to show that E0 [v | D] − E0 [v | O] > 0 for some parameter values. However. all agents report truthfully. note that the difference between the principal’s expected utility under delegation (D) and override (O) is (7) ** * ** E0 [v | D] − E0 [v | O] = pπ(v H ( n * . The intuition is that delegation is optimal when the agency problem is not too severe (α is not too large) but the costs of pooling are high (roughly. override is * costly when n * R is far from the principal’s optimal n in both the M and H states). but prefers delegation for some parameter values when the override equilibrium pools. In the separating case.** Separating equilibrium: When u M ( nR ) < 0 . The easiest way to show this is with a numerical example. Therefore. H ) − v H ( nR ) ) + (1 − p) (vM (n M ) − vM ( nR ) ) Equation (7) is opaque—each of the two terms can be positive or negative. delegation can be optimal. the outcome s i the principal’s global optimum. override dominates delegation in the separating equilibrium. 25 . The principal prefers override to delegation when the override * equilibrium separates ( u M ( n * R ) < 0) . the principal can be better or worse off under override than delegation. In the pooling case. see paragraph (2) below. To see this.

the principal may be able to choose between delegation. This reinforces the message from the veto case that delegation is good for projects with a low upside potential. and p = 0. and override. and the reason is the same: when the principal retains decision rights. Let f ( n) = n − n 2 for n < 0 . A first observation is that a sufficiently low α makes * override optimal. because override is better when the override equilibrium displays separation. (1) What determines whether the principal prefers override or delegation? One way to answer this question is to identify sufficient conditions for * ** ** u M (n * R ) = Mf ( n R ) − (1 − α) nR < 0 . possibly to the principal’s detriment. what might be thought of as routine decisions. L = 0 .Proposition 4 clarifies one issue concerning our key result in Proposition 1. the agent distorts his information transmission.8. veto. 5 . Here is a particular example. delegation can still be optimal.5. A complete comparison of the three processes is algebraically intensive and yields few additional insights.5 . and let H = 4 . This 26 . α = 0. Proposition 4 shows that even if we allow the principal to react in any way to the proposal. (2) In some situations. Second. since n * R is increasing in R. π = 0. One might suspect that delegation outperforms veto there because it restricts the principal’s ability to react to the proposal. But it can be shown that each of the processes is optimal for some parameter configurations. This follows from the fact that n * does not depend on α. and is R somewhat contrary to conventional wisdom—the right to override is more valuable * when agency problems are modest. a sufficiently large R holding constant M makes override optimal.

We shall model this as a process with a spending level. in which the decision is delegated when n ≤ T . and subject to override when n > T . but a budgeting committee must approve large expenditures. and bring out its economic logic. Threshold delegation also is used in corporations and other organizations. we must focus on the case where the 21 The case of threshold delegation with veto (instead of override) is similar. and veto (which separates) generates 0.109.097.21 We want to identify when threshold delegation can be better for the principal than delegation and override alone. The override pooling equilibrium generates an expected payoff for the principal of 0. where managers can approve small expenditures independently.090. Public sector examples of threshold delegation appear in Swiss cantons.* * specification meets all of the model assumptions and u M ( n * H ) > 0 and v R ( n H ) > 0 . and American states where debt issues above a threshold amount trigger referendums. C. T. Override is dominated by delegation—as noted in Proposition 4 —and veto is superior to both override and delegation. Threshold delegation offers no advantage when the override equilibrium exhibits separation because override delivers the principal’s optimal outcome. 27 . Threshold Delegation Another common decision process is a hybrid of delegation and veto/override that we call threshold delegation: a spending level is set below which decisions are delegated and above which they are subject to veto or override. delegation generates 0. Therefore. where new projects that cost more than a certain amount require approval by referendum.

if the * threshold is set below n * R then the project goes forward at a scale no larger than it would 22 A belief structure that supports this equilibrium is the principal assigning a deviation to the H-agent with * * probability 1. even. nH ) gives him a higher payoff than n * H . and the * 22 principal overrides any proposal greater than T with n * The M-agent stays below the H . a pooling equilibrium in which the threshold is ignored may exist. How does the principal fare in this situation? The principal is obviously no worse off in the H state because the proposal ends up at his optimum. To see this. In the M-state. n* is the M < nH H) * following: the M-agent proposes n = min{ nM . Let n M be the (minimum) * project size that gives the M-agent the same payoff as n * H . if it is greater) instead of proposing the smaller project size that would free him from the principal’s oversight. For the purposes of this discussion we assume that n M < nH so that ** 0 * n0 exists. the solution to ** * ** u M (n 0 M ) = u M (n H ) . These are the only “reasonable” beliefs when T ≥ n M . that is. 0 ** * threshold because n ∈ ( nM .override equilibrium features pooling. we need to 0 characterize equilibrium behavior under threshold delegation. so he accepts the override outcome (or T. the H-agent proposes n > T . Threshold delegation can address both problems. When T < n M . The equilibrium under threshold delegation with T ∈ ( nM . 28 . than the agent would choose if he could act without constraint. The problem with override here is that the Magent’s proposal is far too large—larger. throughout this section we assume that the agents play to the separating equilibrium described in the text. The threshold is below the H-agent’s optimal project size. The problem with delegation is that the M-agent and the H-agent pad their proposals. Since the tradeoffs in that case are already discussed above.T } .

Intuitively. For example. The principal prefers threshold delegation with T ∈ ( nM . this is also better for the principal. in which something akin to threshold delegation is shown to be the optimal decision process in a mechanism design framework. n* to R ) delegation and override when the override equilibrium pools. Decisions with limited financial consequences are left to the agent while the principal keeps a hand in expensive decisions. 0 * Proposition 5. The economic function of threshold delegation in our signaling model is to allow the M-agent to separate but still restrain the H-agent. threshold delegation in this equilibrium addresses the override “pooling” problem by allowing the M-agent to separate and addresses the delegation “padding” problem by overriding the H-agent (and possibly by restraining the M-agent).000 threshold that required approval of top management. Our argument is similar to that of Harris and Raviv (1998). Thus. 2000) and probably in corporations.** have under either delegation ( n * M ) or override ( n R ). too. One benefit of t his arrangement is to economize on 23 Our approach and that of Harris and Raviv may overstate the benefits of threshold delegation by ignoring a problem that is important in practice: the agent may (inefficiently) subdivide a large project into several smaller projects in order to evade the spending threshold. see Bower’s (1970. 29 . The same benefit arises if we consider veto instead of override.23 Casual observation suggests that this decision process is common in practice. pages 1516) discussion of a division that built and equipped an entire plant on expense orders in order to avoid the $50. we have the following result. This is a serious problem in Swiss cantons (see Feld and Matsusaka.

T * is decreasing in H. Second. Several implications can be derived 0 0 ** ** from the fact that n M is the solution to Mf ( nM ) − (1 − α) n 0 M = Mf ( nH ) − (1 − α) n H . To prevent pooling. as the agency problem becomes more severe. T * increases as α increases. 30 . Third. A final question of interest is what determines the optimal threshold? Note that the principal wants to set the threshold as low as possible without inducing the agent to 0 pool. which means the optimal threshold is T * = nM .the principal’s time—it is not efficient for him to weed out the smallest inefficiencies. Our analysis suggests that threshold delegation may have another benefit. T * H must be increased to make the two payoffs equal again. First.” the agent is given more discretion. By allowing the agent to overspend “a little” on small projects. it prevents even larger distortions that might occur if the agent had to justify his project to the principal. holding constant M. T * does not depend on p. Somewhat counterintuitively. This mirrors our results above: as the project becomes more “routine. it is optimal to give the agent more discretion. The reason is that an increase in α increases * the M-agent’s payoff from n * more than his payoff from T * .

This extension helps to understand the role of the agent’s information advantage in determining the decision process since the agent’s information advantage declines as q rises. the principal’s utility. the principal now rejects the proposal if his own information reveals that θ = L . the agent’s behavior. We focus on the comparison of delegation and veto (override is essentially the same. Here we extend the model by allowing the principal to learn the state of the world with probability q after the agent makes his proposal. 24 The principal also updates his beliefs and becomes more willing to accept a proposal if his information is M. In particular. This affects the equilibrium outcome. and more subtly. Under the veto process. equilibrium behavior and the principal’s payoff are the same as when the principal is uninformed. the M-agent’s expectation of the state conditional on the principal’s approval is given by R′ = (πH + (1 − q)(1 − π) L ) /(1 − q + πq). an M-agent is more likely to pool now because he can rely on the principal to some degree to reject the project with some probability in the L-state. Therefore. We assume a parameter configuration such that he still finds it optimal to reject a proposal from a separated M-agent. 31 .) Under delegation. Extension: An Informed Principal So far we have assumed that the principal is completely uninformed about θ.24 The M-agent anticipates that the principal will learn that the project’s value is L and reject it with probability q(1 − π ) .V.

the H-agent proposes n H . H ) > u M (n H ) . The other difference when the principal is informed is that veto can be optimal even with a pooling equilibrium. In the separating case. One difference between this case and one with an uninformed principal is in the condition for pooling. To see this. compare the principal’s payoff under delegation and veto. The reason is that the M-agent is more enthusiastic about going forward when he can rely on the principal to eliminate the L project with some probability. the principal accepts a proposal of n H . and rejects the proposal if his information is L or if n ≠ n * H. This is somewhat counterintuitive: we might expect that as the principal becomes more informed.Therefore. the M-agent * proposes n ≠ n * H . delegation will become less desirable. the H-agent and M-agent both propose n * H . and rejects all other proposals. This suggests (as we show shortly) that an increase in q can change the optimal decision process from veto to delegation. the M-agent is willing to pool with the H-agent if u R ′ ( n* H ) > 0 . the principal accepts a proposal of n * H if his information is H or M. here * u R ' (n * Since u R ′ ( n * H ) > 0. * Pooling equilibrium: When u R ′ ( nH ) > 0 . veto is obviously better and does not depend 32 . * Separating equilibrium: When u R ′ ( n * H ) < 0 . The two equilibria take the following form. an immediate implication is that pooling is more likely when the principal is informed.

The first term in (8) is positive and the second is negative. Thus. but a sufficiently large increase makes veto optimal. the principal’s expected payoff is (8) * * * E0 [ v | V ] = π( p + q(1 − p ))( Hf ( n * H ) − n H ) + (1 − p )(1 − q)( Mf ( n H ) − n H ). The bottom line is stated in the next proposition: Proposition 6. For this reason. particularly the initiative and referendum. An increase in the principal’s probability of being informed can make delegation better than veto. the principal’s payoff can be higher under veto than delegation even in the pooling case if he is sufficiently informed. what worked 33 . In the pooling case. “Full Democracy. have enjoyed increasing popularity in the last 30 years. One explanation for this trend is the declining cost of information—citizens now have access to as much information as their representatives.’ … As a result. some have predicted that so-called “direct democracy” is the wave of the future.25 Proposition 6 suggests that the situation 25 An extreme example is a feature in the Economist (December 21. This is because an informed principal can eliminate the objectionable L-project.on q. Public sector decision processes that limit delegation. and is positive for sufficiently large q. Note that E0 [ v | V ] is increasing in q. 1996) titled. “… the defenders of the old-fashioned form of democracy have to face the fact that the world has changed dramatically since the time when it might have seemed plausible to think the voters’ wishes needed to be filtered through the finer intelligence of those ‘representatives. This is because the principal’s information is not used.” It argues.

34 . H} that solves: reasonably well in the 19th century will not work in the 21st century. which allows us to identify optimal mechanisms from among the set of mechanisms in which the principle is capable of committing (costlessly) to a specific project size for each state reported by the agent. The revelation principle states that any decision process can be expressed as an equivalent revelation game in which the agent reports a value of θ and is given an incentive to report truthfully. and that one cost of direct democracy may be distorted information transmission by government officials. it is the n J defined for J ∈ {L. the paper has focused on analyzing the benefits and costs of budget procedures that are observed in practice. subject to truth-telling constraints. call it J ∈ {L. than the representative sort” (page 4). M . Our children may find direct democracy more efficient. More formally. we investigate how these procedures compare to a theoretically “optimal” decision process. M . The optimal mechanism is a mapping of reported states into spending that maximizes the principal’s expected utility. This class of mechanisms assumes a greater ability to commit by the principal than may be realistic. results in a spending level. We search for an optimal process using the revelation principle. Optimal Mechanism from a Revelation Game To this point. H } . In this section. The agent’s report. as well as more democratic. but seems like a natural starting point. VI.could be more complicated.

u J (n J ) ≥ 0 for all J. (11) n J ≥ 0 for all J. Condition (10) imposes truth-telling. for the most part. then (a) n L = n M = 0 and n H = nH . Proposition 7. and condition (11) contains the non-negativity conditions. The next proposition (proved in the appendix) characterizes the solution. if u M ( n H ) > 0 then * * ** either (b) n L = 0 and n M = n H = n * R . 0 ≤ n M < n M < n H . This was noted in Section IV where we saw that override results in the principal’s unconstrained optimum 26 A necessary condition for Case (b) to hold is n R ≤ n M . can be implemented by the actual decision processes studied earlier in the paper. An optimal mechanism n J takes one of three forms depending on the * ** ** parameters: if u M ( n * H ) ≤ 0 . and u M ( n M ) = u M ( n H ) . 35 . K ≠ J . or (c) n L = 0 . but there is no simple expression to delineate (b) ** * and (c).(9) max { pπv H ( nH ) + (1 − p) v M ( nM ) + p(1 − π)v L (n L )} {n J } subject to (10) u J (n J ) ≥ u J ( nK ) for all J .26 The optimal mechanism described in Proposition 7. n H < nH . The mechanism in case (a) can be implemented with an override process.

by granting the agent agenda control power. and allow the H-agent a relatively large project size. First. making pooling undesirable. making separation difficult. full delegation is very common in practice. If n H > n * H . a threshold of T = nM appropriately caps the M-agent’s project size. The only decision process that is never optimal is full delegation. However.(of (9)) when the agent separates. a threshold is useful. because the M-agent spends too much. Otherwise. a spending minimum is necessary. A simple veto process (without a threshold) is an optimal mechanism only in the special case where the solution takes the form of (c) in Proposition 7 with n M = 0 and u M (n * H ) = 0 . This can be seen immediately from Proposition 7—the outcomes n * and n * can never occur in an M H optimal mechanism. the principal commits to allow spending in the * * H state to exceed his personal optimum. Override cannot implement such an outcome because the principal is unable to commit to approve such a large project in the H state. The truth-telling condition is difficult to satisfy here. although in this situation pooling occurs. If n H < nH . as noted above. If the principal’s time is sufficiently valuable 36 . a spending limit equal to n H completes the implementation. Threshold delegation/veto can resolve both of these implementation problems. Case (c) is more complicated. How can this inconsistency be explained? One possibility that comes to mind is that the analysis omits the opportunity cost of the principal’s time. Second. Case (b) can be implemented with the override process as well. Delegation does not work either. The solution is to grant a relatively small project size to the M-agent. and the M state is onerous for the principal. which is the condition for case (a) to apply * ( u M (n * H ) ≤ 0 ). n * H .

this argument for delegation seems more applicable to small projects. 37 . We develop a model in which a principal employs an agent to make budget proposals. Cai. One important direction for future research is to investigate the relation of incentive contracts and decision processes. The principal chooses how much of the decision to delegate to the agent. while many large budgeting decisions (such as the federal budget) are fully delegated as well. delegation could be efficient. and Luo (forthcoming) makes some progress on this issue. The agent prefers to spend more than the principal does. The central tradeoff is this: delegation allows the agent to overspend.27 Casual observation and empirical evidence suggest that actual contracts in the private sector often provide agents with very weak incentives to pursue the principal’s interest (Jensen and Murphy. Conclusion The paper studies the economics of various processes that are used to make budget decisions in public and private organizations. We show how the tradeoff between these two distortions can help understand the choice of decision processes and the behavior of the agent under each process. but limiting delegation induces the agent to distort the information he transmits to the principal in order gain approval of a large project. and incentive 27 Bernardo. and has superior information about project returns. Still. It may be difficult in practice to determine the optimal threshold and spending limits. as seems likely. especially if they vary from project to project and over time. VII. Another explanation could involve unmodeled complexity costs.relative to the potential waste from choosing the wrong project size. 1990).

We show that a well-chosen decision process can result in the principal’s unconstrained optimal outcome in some cases. we argue that some decision processes are effective precisely because they commit the principal to actions that are not in his interest ex post. It may well be that some decision processes that are theoretically optimal in a world where commitment is costless (as with a mechanism design framework) are inefficient in reality because of commitment problems. It is unclear why this is so. so one explanation could be that adroit management of the decision process can address agency problems satisfactorily without having to bear costs of incentive contracts (such as exposing the agent to significant amounts of risk. Our analysis implicitly assumes that the principal can commit to a decision process. It would also be useful to have a deeper theory of commitment. we do not ask why the principal is able to commit to the particular institutions we study and not others.contracts are virtually unheard of in the public sector. however.) This does not seem like an adequate explanation for the complete absence of incentive contracts in most political decisions. A more complete analysis would provide some insight on why the corner solution is so popular. 38 . However. Indeed.

3) (a. K ≠ J .1) subject to (a. Proof: Assume to the contrary that n L > 0 . * Solution (a). as we show in the text. If u M ( n * H ) > 0 . If u M ( n * H ) ≤ 0 . We consider them in order.2)JK (a. pooling and separating. Proof of Proposition 7: The optimal mechanism takes one of three forms. H} that maximizes (a.1) and. n J ≥ 0 for all J. * Solutions (b) and (c). Lemma 1. then the solution is the unconstrained maximum of (a. M . E[ v ] = pπv H ( n H ) + (1 − p )v M ( n M ) + (1 − p)(1 − π )v L (n L ). We begin by establishing two properties of an optimal mechanism.4) u J (n J ) ≥ u J ( nK ) for all J . We will show that n ′ L = 0 yields a higher payoff to the principal and still satisfies the constraints. then the solution can take two forms. u J (n J ) ≥ 0 for all J.Appendix: Proof of Proposition 7 For reference. it can be implemented (with override). The optimal mechanism is the n J defined for J ∈ {L. On the first point. An optimal mechanism satisfies n L = 0 . note that 39 . we restate the mechanism design problem.

As for the constraints. The truth-telling constraints can be restated for the H-agent (a.4) is satisfied by u L ( 0) = 0 . The * * Since n* R ≤ nM by assumption. and for the M-agent (a. then φ( M ) > 0 : the two constraints cannot be satisfied simultaneously.E[ v | n L ] < E[ v | n ′ L = 0] because v L ( n) is decreasing for n ≥ 0 . For n M = n H = n ′ . The proof is completed with a numerical example showing that both pooling and separating solutions can be globally optimal for some parameter configurations. E[ v ] = (1 − p (1 − π )) Rv R (n ′) . and those that separate with n M < n H . the payoff function in (a. those that pool. An optimal mechanism satisfies n M ≤ n H . || Lemmas 1 and 2 imply that there are at most two types of solutions to the * revelation game when u M ( n * H ) > 0 . Solution (b)—Pooling. (a.2)HM as φ( H ) ≥ 0 . Now suppose that n M > n H . We next characterize them and show that a locally optimal solution of each type exists for all parameter values.2)KL hold because u K ( n K ) ≥ u K (0) = 0 for K ≠ L . (a. Constraints (a. Consider a mechanism with n L = 0 and n M = n H = n ′ .2)MH as φ( M ) ≤ 0 . || Lemma 2.1) can be simplified as * unconstrained maximum is n ′ = n * R . we have a strictly 40 .2)LK hold by u L ( 0) > u L (n K ) for K ≠ L . Finally. Proof: This result follows from the agent’s truth-telling constraints. Observe that dφ / dI = f (n H ) − f ( n M ) < 0 . Define φ( I ) = u I ( n H ) − u I ( nM ) . If φ( H ) ≥ 0 .

2)HM to hold.2)MH.2)MH holds with equality. The * set of ( nM . we can show that 00 00 * (a. n H < n H . a maximum exists. n M < nH . the solution is not in general unique. The solution is obviously not at the “compactification” point because n M < n * M . we observe that n M < n * M < n H . Although the objective function is strictly concave. Constraint (a. the smaller value of n M increases E[v] . Suppose there is a solution for which this constraint does not bind. A sufficient condition 41 .2)HM holds because n * H < nH . supposing they exist. and (a.2)HM because n M < n * H. n H ) | n M = n H ≤ n * M }. we show that a solution of this form exists. because n H > nM > n* H . Note that n M < n * H . nM ) . Then an increase in n H increases E[v ]. However. With this in mind. Because the objective function is continuous. Then a smaller value of n M still satisfies (a. n* M ) and n H > nM . nH ) defined by the constraint is compact if we add the point ( n * M .concave function defined on a compact convex set. This must be true for (a. Next. This follows from the fact that (a. which cannot be true for a solution. and u M ( n M ) = u H ( n H ) . Next. Suppose that there is a solution for which this is not the case. If 00 * n M = 0 . and u is ** single-peaked. maximizer n * R exists and is unique. We shall first characterize the separating solution(s). a decrease in n H has the same effect.α) n M = Mf ( nH ) – (1.2)MH binds. and also satisfies (a. Note that the problem can be restated as max E[v ] subject to u M (n M ) = u M ( n H ) for n M ∈ [ 0. The * Solution (c)—Separating with 0 ≤ n M < n * M < n H .α) n* H . {( n M . The last property is n H > nH . Define n 00 M as the solution to Mf ( n M ) – (1.2)MH holds * * * because n H > nM .

5) is nH = nM = . 42 . the pooling solution is the same.4. or 2 equivalently.1. n* M ) . the constraint function ψ is convex. In addition.07. For each example. n H > n M . and π = . nM = .25. ψ′′ ≥ 0 .47.38.5. nM = . Now the pooling solution is the globally optimal mechanism. the separating solution is the globally optimal mechanism. To see precisely that either type of equilibrium is possible. for this f . Let H = 4. Here. so that M = 1.5 and p = . so the separating solution we study is the unique maximum. Finally. || 28 The function ψ is regular convex if the condition u ′ ′ ( nM ) / u ′ M M ( n H ) ≥ (u ′ M ( nM ) / u ′ M ( n H )) holds. the pooling solution to (a. uM( n* H ) > 0). where n is restricted as n < . Let f(n) = n – n2 . If α is changed to .09. with E[v ] = . L = 0.85. with E[v ] = . it is easy to check that all of the assumptions of * our model are met (In particular.8. let α = . is regular convex. whereas the separating solution is nH = . we use an example. Also.with E[v ] = 11. In this case. we show that both pooling and separating solutions can be globally optimal for some parameter values.for uniqueness is that the constraint function n H = ψ(n M ) defined by u M (n M ) = u M ( n H ) 28 for n M ∈ [ 0.3. but the separating solution is nH = .

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