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THE ALLOCATION OF DECISIONS IN ORGANIZATIONS

*



by


Susan Athey, Joshua Gans, Scott Schaefer, and Scott Stern
**





First Draft: 29 November, 1993
This Version: 1994


This paper is motivated by an often-observed but under-studied phenomenon
of the modern business enterprise, management by exception. This term
describes the relative infrequency of management interference in the lower tiers
of an organizational hierarchy. We study how an organization allocates
decisions among agents when the efficient choice of which agent is responsible
for decision-making depends on the state of the world. Two distinct factors
shape the optimal scope of decision-making authority: intrinsic differences and
induced differences. Intrinsic differences arise because, due to considerations of
coordination, information, or incentives, one agent may have a relative advantage
at making the decision in a given state. Induced differences arise because the
overall quality of an agent’s decision-making falls with the number of states over
which he or she has discretion. Management by exception as a phenomenon may
arise when scarce managerial resources are conserved by restricting the scope of
managerial authority. We examine the effects of shifts in the probability
distribution over states, focusing on shifts which increase the relative frequency
of states where high-level decision-makers have an intrinsic advantage. We
show that in response to such a shift, which might arise if the organization’s
environment becomes more complex, the optimal scope of low-level decision-
making increases. Finally, we analyze complementarities between discretion and
other organizational design variables. This paper represents a first attempt at
elucidating a formal theory of state-contingent decision-making within
organizations. Journal of Economic Literature Classification Numbers: D23 &
M12.


*
The authors would like to thank Paul Milgrom and John Roberts for their guidance and encouragement.
We also thank Tim Bresnahan, Cathy Fazio, Rachel Hayes, Meg Meyer, Robin Wells, Jeff Zwiebel, and
participants in the Comparative Institutional Analysis Workshop at Stanford University for helpful
comments and discussions. Financial support from the National Science Foundation (Athey & Schaefer),
State Farm Companies Foundation (Athey & Schaefer), Fulbright Commission (Gans), Bradley Foundation
(Stern), and a Stanford University Lieberman Fellowship (Athey) is gratefully acknowledged. All errors are
exclusively the responsibility of the authors.
**
Athey and Schaefer are of the Graduate School of Business, Stanford University; Gans (University of
New South Wales); and Stern (Department of Economics, Stanford University). Please address
correspondence to Joshua Gans, Dept of Economics, University of NSW, Sydney, NSW 2052, Australia; E-
Mail: J.Gans@unsw.edu.au.

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Keywords: discretion, management by exception, training, complementarities,
organizations, decision-making.
3


Contents

I. Introduction 3
II. The State Space 7
III. The Organization’s Objectives and Choices 9
IV. The Allocation of Decisions 11
V. Changes in the Organization’s Operating Environment 16
VI. Changes in Worker and Manager Effectiveness 27
VII. Interpretations and Extensions 30
Appendix: Proofs 33
References 36
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I. Introduction
This paper presents a theory of the optimal allocation of decisions within
organizations. We are motivated by management by exception, a commonly observed
phenomenon in the modern business organization. Management by exception describes
an organizational style characterized by the relative infrequency of managerial decision-
making, where managerial authority over decision-making is reserved for those cases
when “exceptions” occur. An interesting feature of management by exception is that
decision authority depends upon the firm’s current environment. For this reason, we
analyze the assignment of decision-making authority under contingency plans: the choice
of which agent makes the decision is allowed to change based on the period by period
resolution of uncertainty. Our goal is to understand the forces that shape such decision
allocation rules, as well as which economic environments result in management by
exception. We explore, in some detail, how the optimal decision allocation rule changes
with the probability distribution over potential contingencies. We complete our current
analysis of “state-contingent” decision-making by analyzing decision allocation as part of
a system of human resource management variables.
The stochastic nature of the organization’s operating environment is a central
ingredient in our analysis. For example, a job shop manager within a manufacturing
organization faces uncertainty, on a day-to-day basis, about such factors as how many
machines will be operational during her shift, how many workers will call in sick, and
whether or nor a design defect will be discovered in the product. The organization cannot
be redesigned each time the uncertainty is resolved; thus, the organization considers the
probability distribution over uncertain events when it creates the contingency plan for
decision allocation.
Our treatment of decision-making as state-dependent contrasts with previous
analyses where the organization must decide ex ante which agents make all decisions of a
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certain type.
1
We are interested in who makes a given decision in different states of the
world. Therefore, we consider a situation in which the same decision must be made
repeatedly, but rules imposed by the organization determine which agent makes the
decision at each point in time.
Our framework can be applied to a very general class of organizational design
problems.
2
However, to build intuition about the role of organizational rules in
determining the allocation of decisions, let us consider the allocation of patient treatment
decisions between physicians and nurses within a hospital setting. There are strict limits
on the level of discretion given to nurses. For example, in most hospitals, nurses are
allowed to make incremental adjustments to intravenous (IV) regimens, but they are not
allowed to prescribe new drugs. If a patient develops symptoms which may require new
drugs, the nurse does not make the treatment decision; rather, she simply reports that the
physician’s attention is needed. The physician is then responsible for the treatment
decision, in this case the choice of a new prescription drug. We argue that the
nurse/physician relationship is an example of management by exception. Nurses have
discretion over the treatment decision for routine illness states, but they recognize and
report exceptional states to the physician. In this respect, authority over treatment
decisions is allocated on a state-contingent basis. The American Nursing Association
(ANA) has pointed out the centrality of decision allocation (as opposed to task
assignment). In choosing to advocate against the integration of nurses into “physician
assistant” programs during the 1970s, the ANA maintained that “the question is not who
does what, but who prescribes and who delegates to whom” (Brown, 1985, p. 178).
In this paper, our goal is to characterize the optimal allocation of state-contingent
decision authority between agents in an organization. Clearly, decision authority should

1
Examples of this previous literature include Cremer (1980), Aoki (1986), Sah and Stiglitz (1986, 1988,
1991), Itoh (1987, 1992), Geanakoplos and Milgrom (1991), Radner (1992, 1993) and Borland and
Eichberger (1993).
2
For example, within a manufacturing context: What quantity should be produced by a plant this period?
How should given, scarce capital resources be allocated within a job shop? These decisions are assigned to
different decision-makers within the firm at different points of time, depending on the particular situation
that the firm finds itself in.
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be shaped by the relative effectiveness of each agent as a decision-maker. We distinguish
between two distinct factors which determine relative effectiveness: intrinsic
effectiveness, due to the underlying qualities of agents and their positions within the
organization, and induced effectiveness, due to the scope of decision-making assigned to
each agent.
Differences between the intrinsic effectiveness of two agents in a given state of the
world may arise from any of the following differences between agents: the education or
talent of the agents (as in the case of physicians and nurses); the local and global
information possessed by each agent; the wages of the agents; the ability of the
organization to provide effective incentives for each agent (for example, there might be
differences in the precision with which the firm can observe each agent’s effort); or the
ability of each agent to coordinate with other parts of the organization.
3
We will not limit
ourselves to any one of these; rather, we study how an organization should be designed
conditional on the fact that intrinsic differences exist between agents. For expositional
ease, we will distinguish agents as being low-level versus high-level. In the example of
the modern business hierarchy, low-level agents are those who, in general, have less
education or talent, more local and less global information, and can coordinate with the
rest of the organization only at a relatively high cost.
In contrast to intrinsic differences, differences in induced effectiveness arise because
the scope of decision-making assigned to each agent may negatively affect the agent’s
performance in each state over which she has authority. For example, recognizing
doctors’ limited time and attention, their effectiveness at prescribing appropriate drug
regimes results in part from the fact that they do not make the (sometimes hourly) IV
regimen decisions for each individual patient in their care. If physicians were to make

3
Jensen and Meckling (1992) analyze the costs and benefits to decentralized decision-making in terms of the
incentive costs and the benefits to using local information.
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these incremental adjustments, they would have fewer resources available (time,
concentration, etc.) to master the arts of diagnosis and prescription.
4

Allowing the scope of decision authority to change the relative effectiveness of
agents is a novel feature for formal organizational analysis. This feature is useful because
it helps us identify and understand important aspects of decision authority. For example,
a first result of our analysis is that, in general, there will be states of the world where the
assigned decision-maker is not the agent with the highest effectiveness in that state. This
is driven by the fact that decision assignment not only reallocates marginal states to one
agent or another, but further choice of discretion can affect an agent’s performance on
inframarginal states. When the inframarginal costs of managerial decision-making are
high, they sharply constrain the scope of managerial authority and management by
exception can result: low level agents are given discretion in all but a few states, the
exceptions.
Next, we address a central question in the design of organizations under uncertainty:
How does the choice of discretion change with the probability distribution over states?
The probability distribution could reflect the complexity or the nature of the underlying
uncertainty in the organization’s environment. Changes in the firm’s production
technology, industry, or economy, as well as changes in the organizational structure of the
firm, will change this probability distribution. We find that, under very general
conditions, an increase in the likelihood of states where the high-level decision-maker is
intrinsically better leads to an increase in the discretion of the low-level agent. This
comparative static is driven by the effects of discretion on the induced effectiveness of
both agents. However, we also identify the potential for confounding effects to arise
when the organization is characterized by “competing management regimes,” that is,
when there is more than one locally optimal choice of discretion.

4
The importance of decision scope on decision quality has been explored, experimentally, within the
psychology literature. In the case of physician decision-making, there is a growing experimental literature
on the negative effect of complexity and decision scope on decision quality (Chinburapa et. al., 1993).
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The remainder of this paper is organized as follows. In the next two sections, we
develop the precise nature of the state space over which the organization allocates
decision authority as well as the optimization problem of the organization. We then
characterize the organization’s optimal decision authority structure and show how that
solution depends on the relative importance of intrinsic and induced effectiveness. In
Section V, we use our framework to analyze the question of how decision authority
changes as a result of changes in the organization’s operating environment. Finally,
Section VI explores how decision authority interacts with other human resource
management variables of the organization, such as training.
II. The State Space
This section introduces the framework in which we will analyze the question of how
decisions are allocated between two agents. For expositional purposes, we will
concentrate on the decision allocation problem in an organization with two levels, and we
will phrase our analysis in terms of the optimal amount of discretion given to the low-
level agent.
5
Moreover, we will refer to the low-level decision-maker as the worker and
to the high-level decision-maker as the manager. As discussed above, the allocation of
decisions between workers and managers will be state-contingent: that is, the optimal
choice of who makes a decision at a given point in time changes with the current state of
the world. This choice will clearly depend on the relative effectiveness of the two agents.
The allocation of decisions between workers and managers depends on how
differences between them affect their relative decision-making effectiveness when certain
events arise. Consider the case of an assembly line, where two employees, a foreman (the
worker) and a central office executive (the manager), can potentially decide what the
production volume should be on a given shift. Random variables which affect their

5
While our interpretation is a vertical hierarchy, nothing in the model depends on that assumption. Our
model can be applied to any situation in which decisions can be allocated between two agents who have
different information or resources. The lines of command are not part of our story.
9

relative decision-making ability could include the number of functional machines, the
production requirements for other parts of the assembly line, market and demand
conditions, the financial state of the company, or on-hand inventory. Now, let us compare
the difference in intrinsic effectiveness for two different event outcomes, or states: (A)
“One of the assembly line workers called in sick today” and (B) “The machines in this
segment of the line have produced defective output for three shifts in a row.”
In A, the foreman is likely to possess useful information about the abilities of her
workers to adapt to different, temporary job assignments; further, the way in which the
line workers are assigned will probably have little impact on other factors external to the
line that affect the organization’s productivity. In contrast, the central office executive is
unlikely to possess the relevant information to make a good decision; thus, the foreman
can make a relatively effective daily output decision when event A occurs. Determining
daily output when event B occurs, on the other hand, may require consultation with many
branches of the organization, including trained maintenance specialists, engineers, and
accountants. In this case, the manager might be more effective. Comparing these two
events, the relative benefits to having the worker (the foreman) take the decision in event
A are higher than those in event B.
For any particular random event outcome, the effectiveness of workers and
managers can be compared. Our focus on the allocation of decisions between two agents
allows us to summarize the stochastic environment with a single index, s, which measures
the difference in the benefits which accrue to the firm from assigning the decision in a
given state to the high-level rather than the low-level decision-maker. In the assembly
line example,
s
A
< s
B
: holding all else constant, the organization accrues greater returns
from high-level decision-making under event B than under event A.
Each state, s, comes from a state space, S = [0,1]. We define t
W
(s) and t
M
(s)
(where each function maps [0,1] ÷9) as the benefit to the organization in state s if the
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decision is allocated to the worker or the manager, respectively.
6
By construction,
t
W
(s) ÷t
M
(s) is decreasing in s. The probability density function over the state space,
denoted f(s), represents the probability that a given state s occurs. This density is
determined by the probability distribution over the underlying random variables. We
assume throughout that f has full support.
Thus far, we have not discussed other organizational choice variables which might
affect the quality of worker or manager decision-making, such as internal communication
channels and information flows, the incentive scheme, and the personnel of the
organization. We define the state space for an arbitrary organizational profile; in Sections
V and VI, we will examine the effects of exogenous and endogenous changes in this
profile.
III. The Organization’s Objectives and Choices
Before turning to the rules that characterize the organization’s optimal allocation of
decisions, we must precisely state its objectives and choice alternatives. We assume that
the organization’s decision problem has two stages: the organizational design stage and
the decision-making stage. In the organizational design stage, the organization
maximizes expected profits by choosing D, the set of states where the worker has
discretion. In the decision-making stage, a state s is realized. If the state s is in D, then
the worker makes the decision; otherwise, the manager makes the decision. Denote by
D the measure of set D, where d e[0,1] represents an arbitrary value of this measure.
In the organizational design stage, the organization chooses the allocation of
decision-making by state to maximize expected benefits, given as follows:
H D ( ) = t
W
(s, D ) · f (s) · ds
seD
í
+ t
M
(s, D )· f (s)
seD
í
· ds.

6
We will assume that t
W
and t
M
are continuous. For expositional convenience, we will also assume that
t
W
and t
M
are twice differentiable; however, this assumption is not necessary for any of our results.
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In this expression, we see that the firm receives payoffs from the worker’s (manager’s)
benefit function in the region of worker (manager) discretion. In order to analyze our
motivating example, management by exception, we examine an organization which
allocates low-ordered states to the worker and high-ordered states to the manager. To
ensure this separation of the state space between the worker and manager, we impose the
following condition:
¬d e[0,1], t
W
(s,d) ÷t
M
(s,d)
| |
· f (s) is decreasing in s. (A1)
Assumption (A1) ensures that D is a convex set.
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It says that the density is not increasing
“too fast” in low-ordered states nor decreasing “too fast” in high-ordered states. To see
that (A1) implies that the organization’s choice of D is convex, fix any choice of d (the
measure of states over which the worker has discretion). If the organization is
constrained to choose the best set D such that D =d, which states should be allocated to
the worker? For any s
H
, if that state is allocated to the worker, then any s
L
< s
H
is also
allocated to the worker if and only if
t
W
(s
L
,d) ÷t
M
(s
L
, d)
| |
· f (s
L
) > t
W
(s
H
,d) ÷t
M
(s
H
, d)
| |
· f (s
H
).
But, under (A1), this inequality is always satisfied. The optimal policy of the
organization is thus to choose a level of worker discretion, d, such that the worker is
allocated states s in
[0,d]
, while the manager is responsible otherwise. Assuming (A1),
the organization’s optimization problem can be rewritten so that the organization chooses
the level of discretion, d, to maximize
H(d) = t
W
(s,d) · f (s) · ds
0
d
í
+ t
M
(s,d) ·
d
1
í
f (s)· ds.
The remainder of this paper focuses on the properties and comparative statics associated
with d, the organization’s choice of the level of worker discretion. For expositional
convenience, we will maintain the assumption throughout that in each agent potentially

7
This assumption is not critical, since it would be possible to analyze the firm’s choice of the scope of
worker and manager discretion even if the region of discretion is not an interval; however, A1 significantly
simplifies the exposition of this paper.
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has an absolute advantage over the other in at least one state: that is, t
W
(0,0) >t
M
(0,0)
and t
W
(1,1) <t
M
(1,1) .
The organization’s choice of discretion also determines the frequency of worker
decision-making, given by
F(d) = f (s)· ds
0
d
í
. Thus, for a given distribution of the state
space, increasing discretion always involves an increase in the frequency of decision-
making. When examining the effect of changes in the distribution of states, as we do in
Section V, the distinction between scope and frequency becomes more salient. This is
because a change in the distribution of states may result in an increase in the optimal
scope of decision authority, while simultaneously decreasing the relative frequency of low
level states.
IV. The Allocation of Decisions
In this section, we make use of the state-contingent framework to explore the forces
which shape the firm’s choice of discretion. Let us begin by analyzing briefly the
situation in which the amount of discretion has no effect on the quality of decision-
making (i.e., t
d
W
= 0 and t
d
M
= 0 ).
8
In this case, the following simple rule guides the
optimal allocation of decisions: allow the worker to make the decision in all states such
that t
W
(s) >t
M
(s) and have the manager make the decision otherwise. The optimal
discretion point (d) corresponds to the state where managers and workers perform equally
well, as given by t
W
(d) =t
M
(d). This situation is depicted in Figure 1.
Restricting the organization’s problem so that only differences in intrinsic
effectiveness are relevant, the solution is particularly straightforward -- the better agent is
allocated the decision. This is a convenient starting point for our analysis, since the
simple rule captures the implicit structure of allocation solutions in the existing literature
(i.e., in team theory). For example, in Marschak and Radner (1972), the organization

8
Subscripts denote partial derivatives. Various smoothness assumptions are made for ease of exposition in
proofs to follow and does not play a critical role in the stated results.
13

allocates states by determining which agent will have access to more useful information
in that state. In their analysis, the scope of an agent’s decision-making does not enter the
organization’s calculus.
But is such an assumption reasonable? Earlier, we argued that physician
effectiveness at treatment decisions is, in part, a function of the scope of nurse discretion.
When the nurse has the discretion to provide treatment for many non-serious illness
states, the physician can devote more resources toward the small number of critical
treatment decisions which she is allocated. Simon (1976) recognized that organizations
face such a tradeoff:

It is not enough to take into consideration the accuracy of the decision; its cost must be
weighed as well. The superior is presumably a higher paid individual than the
subordinate. His time must be conserved for the more important aspects of the work of
the organization. If it is necessary, in order that he may make a particular decision, that
he sacrifice time which should be devoted to more important decisions, the greater
accuracy secured for the former may be bought at too high a price (Simon, 1976, p. 236).
We now turn to the case where differences in effectiveness can be induced by the
allocational choice itself. That is, we examine the consequences of congestion in
decision-making.
Definition. An agent is said to be congested if the quality of decisions in all states is
lowered as the measure of states over which she has discretion is increased.
Congestion amounts to assuming the following:
t
d
W
s 0 and t
d
M
> 0 (A2)
As an agent’s decision-making authority is increased, the quality of that agent’s decisions
is reduced in all states. Congestion results from several effects, including the need for
additional preparation for more contingencies or the increased frequency of decision-
making. In either case, the implication is the same -- decision-making quality is
decreasing in discretion.
While we can think about congestion as an effect whereby increased discretion
spreads a decision-maker’s given human capital investments thinner, we might also
construct a dynamic model where worker benefits depend in part on how much the
decision-maker needs to adjust from the previous period, with greater adjustments being
14

more costly. For any fixed probability density over states, increasing discretion increases
the expected adjustment the decision-maker must make in any period, thus lowering
expected profits in all states. However, in this paper we will not formally model the
underlying causes of congestion.
Assuming, in addition to (A1) and (A2), that the optimum is interior, the
consequences of congestion can be seen through a direct examination of the
organization’s first-order condition, with any optimal d (denoted d
*
) satisfies:
t
M
(d
*
,d
*
) ÷t
W
(d
*
, d
*
)
| |
· f (d
*
) = t
d
*
W
(s, d
*
) · f (s) · ds
0
d
*
í
+ t
d
*
M
(s,d
*
) · f (s) · ds
d
*
1
í

The left-hand side of this expression describes the difference between worker and
manager effectiveness at the discretion point, that is, the largest state which is allocated to
the worker. In general, the right hand side of this expression will be non-zero. Thus, at
the optimal discretion point, there will be a difference between the effectiveness of the
worker and the manager. An immediate consequence is that there will be a set of states in
which the agent to whom the decision is allocated is not the most effective agent in those
states, as illustrated in Figures 2 and 3. This “misallocation” of states results because
organization balances the expected value of the inframarginal benefits from congestion
with the expected value of the marginal benefits associated with allocating each state to
the most effective agent. This insight leads to our first proposition:
Proposition 1. Under (A1) and (A2), generically, t
M
(d
*
,d
*
) =t
W
(d
*
,d
*
) (where d
*
is
an optimal discretion point).
If t
M
(d
*
,d
*
) <t
W
(d
*
,d
*
) , then the manager is allocated states in which she has lower
effectiveness than the worker. Because the manager is assigned decisions in which she is
relatively ineffective, we refer to her as “the meddlesome manager” (Figure 2).
Conversely, if t
M
(d
*
,d
*
) >t
W
(d
*
,d
*
) , then the worker is allocated states in which she
has lower effectiveness than the manager. Because the manger is not assigned all states in
which she has absolute advantage, we call her “the hands-off manager” (Figure 3). These
two distinct organizational regimes (Figures 2 & 3) represent more sophisticated
15

allocation rules than the simple rule considered earlier. Whether management is
meddlesome or hands-off, there exists states where the agent allocated the decision is not
the “best” decision-maker in that state.
To see the intuition behind this result, note that the organization’s chosen discretion
point is analogous to the monopolist’s price. Rather than setting price equal to marginal
cost, the monopolist accounts for the losses on inframarginal units. Similarly, the
organization allocates decisions keeping in mind that an increase in the agent’s
responsibilities affects her ability in states she has already been allocated. This effect
introduces a “wedge” between the decision-making abilities of the worker and the
manager at the discretion point.
The existence of congestion is at the heart of the organization’s decision to allocate
states to agents who are not the best decision-makers. The relative costs of congestion,
appropriately weighted by the probability density, determine the style of management
which is optimal for the organization. However, any particular discretion point in the
state space might be optimal for an appropriately constructed probability distribution;
thus, it is useful to characterize which potential discretion points correspond to the two
management regimes. Let At(s;d) ÷ t
M
(s;d) ÷t
W
(s; d) . As illustrated in Figure 4, it
turns out that At(d;d) is nondecreasing in d under assumptions (A1) and (A2):
c
cd
At(d;d) | |=t
s
M
(d,d) ÷t
s
W
(d,d) +t
d
M
(d,d) ÷t
d
W
(d, d) >0
Thus, there will exist a “critical” discretion point, d
C
e[0,1], such that a choice of
discretion d e[0,d
C
] leads to a regime of meddlesome managers (At(d;d) s 0), while a
choice of discretion d e[d
C
,1] leads to a regime of hands-off managers (At(d;d) > 0).
We are interested in characterizing the management regime which obtains at the
optimum. While in general, the optimal choice of discretion is determined by a balancing
of effects between the expected costs of congestion for each worker, we now turn to a
stylized example where the optimal regime is unambiguous. “One-sided congestion,” in
which only one agent’s decision-making effectiveness depends on the level of decision
16

scope d, illustrates the management regime which results when the congestion costs for
one agent are dominant.
Proposition 2. Under (A1) and one-sided congestion, the organizational regime is
unambiguous.
(i) (Worker Congestion Only) If t
d
M
= 0 and t
d
W
s 0 (with strict inequality for some s),
then management is meddlesome. At the optimal level of discretion (d
*
),
t
M
(d
*
,d
*
) <t
W
(d
*
,d
*
) .
(ii) (Manager Congestion Only) If t
d
W
= 0 and t
d
M
> 0 (with strict inequality for some
s), then management is hands-off. At the optimal level of discretion (d
*
),
t
M
(d
*
,d
*
) >t
W
(d
*
,d
*
) .
PROOF: We will state the proof for the case where the optimum is an interior one
(i.e., d
*
e(0,1)). Since the objective function is continuous in d, the result
follows from the first-order conditions:
(i) t
M
(d
*
,d
*
) ÷t
W
(d
*
, d
*
)
| |
· f (d
*
) = t
d
*
W
(s, d
*
) · f (s) · ds
0
d
*
í
< 0
(ii) t
M
(d
*
,d
*
) ÷t
W
(d
*
, d
*
)
| |
· f (d
*
) = t
d
*
M
(s,d
*

d
*
1
í
f (s)· ds > 0.
The strict inequalities follow from the assumption that f has full support.

This result demonstrates the role of congestion in determining the organizational
regime. Let us consider an example where managers are meddlesome. Each line worker
on a mass production assembly line is assigned a specialized task, involving the assembly
of a manufactured good, such as a component of an automobile (see Womak et al., 1990).
Consider the decision of whether or not a particular component should be sent to the next
worker on the assembly line. In the most common contingency -- when the component is
normal -- the line worker is allocated the decision, and she has the authority to send the
part down the line. There also might be common defects which require a standard
solution: the worker places the part in the queue to be reworked. However, the worker’s
discretion is narrow. If the component is at all unusual, the worker is instructed to
remove the component from the line, alert a superior and return to the line. The discard
decision is then allocated to the superior (or a specialist). Even when this decision is
17

obvious, the organization incurs the cost of having the superior make this determination
and decision.
As implied by Propositions 1 and 2, the narrow scope of discretion results from the
high congestion costs that line workers experience. Being prepared to handle a number of
different contingencies would force workers’ attention away from achieving high
efficiency during the most common contingency -- when the component is assembled
correctly. In other words, to exploit the benefits of specialization, workers’ discretion is
limited to the contingency where there are routine problems or no problems at all.
We can now focus our analysis back onto the phenomenon which motivated our
inquiry, management by exception. Management by exception is defined as a scenario
where managers intervene on a state-contingent basis, and only when relatively infrequent
“exceptions” occur. As the frequency of managerial decision-making is jointly
determined by the probability distribution over states and the scope of managerial
authority, our analysis identifies three distinct forces which can lead to management by
exception. First, we believe that in many organizations the density over states is
downward-sloping; that is, the contingencies where the manager has an absolute
advantage happen relatively infrequently. Second, organizations are often designed so
that workers have an intrinsic advantage over managers in many states of the world, for
example due to considerations of local information or specialization. Third, congestion
costs increase as one travels up the organizational hierarchy. As Alfred Sloan, as CEO of
General Motors, described, “My office force is very small. That means we do not do
much routine work with details. They never get up to us. I work fairly hard, but it is on
the exceptions ... not on routine or petty details” (1924, p.135; italics added). The high
relative cost of managerial congestion means that an organization will allocate many
decisions to workers, even though the manager has an absolute advantage in that
contingency (hands-off managers). This is the implication of Propositions 1 and 2 -- the
18

high managerial congestion costs will lead to relatively infrequent managerial decision-
making.
9

V. Changes in the Organization’s Operating Environment
In this section, we analyze how the optimal choice of worker discretion changes in
response to a shift in the probability distribution over states. In particular, we focus on
shifts in the probability distribution which increase the relative likelihood of highly
ordered states. This type of shift results from a change in the nature of uncertainty faced
by the organization, which can be interpreted as an increase in the complexity of the
organization’s operating environment. Our main result establishes general conditions
under which worker discretion increases as a result of such an increase in complexity.
There are many cases where changes in the probability distribution over states may
be important. Let us build upon one of our motivating examples -- the degree of
discretion afforded hospital nurses. Currently, nurses are not allowed to prescribe drugs.
This limitation on nurse discretion reflects a decision allocation rule which arose from a
particular historical distribution of states. Over time, there has been a substantial change
in this distribution. The diffusion of sophisticated electronic diagnostic devices, coupled
with significant advances in medical knowledge, has reduced the likelihood of events
where nurses have an intrinsic advantage (the low states). Further, innovations such as
the myriad applications of the laser have resulted in an increase in the relative frequency
of physician decision-making (Gelijns and Rosenberg, 1994). Our goal in this section is
to analyze how rules, such as the level of nurse discretion, should change in response.

9
In formal economics, management by exception has received very little treatment beyond the seminal work
of Marschak and Radner (1972, Chapter 6). To Marschak and Radner, management by exception is a type
of information structure that lies between complete centralization and complete decentralization, where the
signal space is partitioned into “exceptional” and “ordinary” signals. Marschak and Radner’s analysis
addressed the issue of the optimality of various information structures; in their framework, management by
exception is optimal. Our work contrasts with theirs in that our main focus is on the comparative statics of
discretion when there are changes in the organization’s operating environment. Further, as noted above,
they do not consider congestion costs.
19

To begin, we specify the types of shifts in the distribution which we will analyze.
Consider a parameterized family of densities, f (s;u):S×O÷9
+
. Let the parameter u
shift the density function so that the high states are relatively more likely as u increases:
The likelihood ratio, f (s;u) f (s;
'
u ), is monotone increasing in s for u >
'
u . (A3)
Under (A3), we say that f (s;u) has the strict monotone likelihood ratio property (MLRP).
Increases in u shift the mass of the density in a particular way, so that highly-ordered
states occur relatively more frequently. Note that this ordering is stronger than the
commonly used ordering of first-order stochastic dominance (which requires only that the
distribution function decreases at all points); assumption (A3) restricts how u affects the
density at every state.
A shift in u reflects a change in the organization’s operating environment. In the
case of our motivating example -- the level of nurse discretion -- the introduction of new
medical technologies has decreased the relative frequency of situations where nurses have
traditionally been allocated decision-making authority. Beyond the physician/nurse
example, analyzing changes in the distribution of the state space provides insight into a
number of problems in the comparative statics of organizational design. When the
manager’s comparative advantage arises from access to global information or an ability to
coordinate, an increase in u corresponds to an increase in the relative likelihood of events
where the decision is relevant to the rest of the organization, and a decrease in the relative
likelihood of events where local information is important and the decision is “self-
contained.” Further, consider the case of a manufacturing firm. Here, a change in the
composition in demand, such as the proportion of customers with customized orders,
could be parameterized as a shift in u. In each of these examples, state-contingent
decision-making is a consequence of the inherent uncertainty in the operating
environment. Varying this uncertainty leads to the adoption of different rules for the level
of worker discretion.
The main result of this section is that, under very general conditions, worker
discretion is monotone nondecreasing with the shift parameter, u. We will first discuss
20

the economic intuition involved in the result. In particular, we identify the forces which
work for and against a monotonic relationship; further, we will describe the unique
circumstance in which the comparative static does not hold globally. We will then state
our main proposition in its most general form, discuss its proof, and highlight the factors
which underlie the potential non-monotonicity. We present three corollaries which
describe three easily interpretable conditions under which the monotone relationship
holds globally: one-sided congestion, quasi-concavity of the benefit function, and
concavity in congestion. The discussion of these corollaries highlights the robustness of
our result as well as the conditions under which a non-monotonicity may arise. Finally,
we interpret our result within the context of our motivating examples.
The Relationship Between Discretion and u
To begin our discussion, we note that congestion is central to the question at hand,
as the distribution of states does not affect discretion in the absence of congestion. When
no congestion effects are present, decisions are allocated to the agent whom is “best” in
that state (recall Figure 1). Being “best” in a particular state is unaffected by the
distribution of states in the absence of congestion. Thus, throughout this section, we
assume that at least one agent experiences a congestion effect.
There are two forces which shape the optimal choice of discretion. The first is the
effect of the level of discretion upon the benefit function in inframarginal states, due to
congestion. Considering only the inframarginal effects, an increase in u unambiguously
increases the returns to raising worker discretion. Intuitively, the shift in u lowers the
probability weight on the low states, where worker congestion effects are relevant, while
the shift simultaneously increases the probability weight on high states, where managerial
costs are relevant. Worker discretion is increased to alleviate the increased salience of
managerial congestion costs.
However, there is also a second, more subtle, force at work. Recall from
Proposition 1 that the firm assigns some states to agents who are not the most effective in
those states. When deciding whether or not to increase discretion, the firm must also
21

consider the impact of reallocating intermediate states from the manager to the worker.
Reallocating these states can either raise or lower the firm’s benefit function, depending
on which agent is more effective in those states. The interaction of u with firm payoffs in
these intermediate states is ambiguous in general; thus, u does not universally increase the
returns to increasing discretion. Our analysis highlights conditions under which, despite
this mitigating effect, a monotone relationship between discretion and u is ensured.
The only case in which potential non-monotonicities arise occurs when the
organization is choosing between two discretion points from two different management
regimes. Consider the case where the firm compares d
L
, which is characterized by
meddlesome managers, and d
H
, which is characterized by hands-off managers. In
increasing discretion from d
L
to d
H
, the firm reallocates the states between d
L
and d
H

from the manager to the worker. Reallocating the states just above d
L
to the worker
increases firm payoff in those states, since the worker is better than the manager (by the
definition of meddlesome managers); however, reallocating the states just below d
H
to
the worker decreases firm payoffs in those states, since the manager is better than the
worker (by the definition of hands-off managers). An increase in u increases the
likelihood of the latter set of states relative to the former set of states; thus, increasing u
potentially makes d
L
more attractive relative to d
H
. Intuitively, u increases the relative
costs of “misallocating” higher states to the worker (when the manager has an absolute
advantage), while at the same time u decreases the relative costs of “misallocating” lower
states to the manager (when the worker has an absolute advantage). This creates a force
which favors the meddlesome management regime over the hands-off management
regime.
The potential non-monotonicity, where the firm chooses to “jump” from a regime of
hands-off management to a regime of meddlesome management, arises only when the
firm faces local optima in each management regime, and thus the comparison between the
discretion points from each regime is relevant. As we will discuss below, several natural
restrictions on the problem rule out the possibility of competing local optima and thus
guarantee a monotone relationship between discretion and u. For example, a monotone
22

comparative static holds when there are diminishing returns to decreasing an agent’s
scope of authority (in terms of reducing congestion costs in an agent’s benefit function).
A Monotone Relationship Between Discretion and u in Each Regime
In this subsection, we analyze precisely the relationship between discretion and the
complexity of the organization’s operating environment, as parameterized by u. We
begin our formal analysis by recalling from Section IV that we can partition the space of
potential discretion points into two regions: the lower region, S
MM
÷[0, d
C
], which is
characterized by meddlesome managers; and the higher region, S
HO
÷[d
C
,1], which is
characterized by hands-off managers. The following proposition guarantees that when the
organization is restricted to choose a level of discretion within one regime, the
(constrained) optimal choice of discretion is nondecreasing in u.
Proposition 3. Under assumptions (A1), (A2), and (A3), any function
d
MM
*
(u) = arg max
deS
MM
H(d;u) or d
HO
*
(u) = arg max
d eS
HO
H(d;u) is monotone nondecreasing in u.
The proof of this proposition is in the appendix; here, we sketch the arguments behind the
proof. We proceed by analyzing the conditions under which the objective function has
the (strict) single crossing property in (d;u); intuitively, the single crossing property
requires that if the organization is choosing between two candidate levels of discretion,
d
H
and d
L
, where d
H
> d
L
, then if the firm prefers d
H
for a particular value of u.
increasing u will never cause the firm to prefer d
L
.
10
We focus on this property because
Milgrom and Shannon (1994) have shown that the single crossing property is both a
necessary and sufficient condition for monotone comparative static relationships, such as
the one considered here.

10
The formal definition follows:
Definition. A function h : X × T ÷9 has the single crossing property in (x;t) if for all x
L
, x
H
eX such
that x
L
s x
H
and for all t
L
, t
H
eT such that t
L
< t
H
, h( x
H
; t
L
) > h(x
L
; t
L
) implies h( x
H
; t
H
) > h(x
L
; t
H
)
and h( x
H
; t
L
) > h(x
L
; t
L
) implies h( x
H
; t
H
) > h(x
L
; t
H
) . The function h : X × T ÷9 has the strict single
crossing property in (x;t) if h( x
H
; t
L
) > h(x
L
; t
L
) implies h( x
H
; t
H
) > h(x
L
; t
H
) .
23

To better understand the factors which influence the firm’s choice of discretion,
examine Figure 5. Figure 5 presents a state-by-state comparison of the benefits which
accrue under two potential discretion points, d
L
and d
H
. There are three distinct regions
in Figure 5. The first and third regions reflect only inframarginal forces resulting from
congestion -- changing the level of discretion from d
L
to d
H
lowers the benefits in low
states and increases benefits in high states. The intermediate region, [d
L
,d
H
],
incorporates congestion effects as well as the effects of reallocating states between agents.
The two discontinuities in Figure 5 result from the fact that, between d
L
and d
H
, states
which had been assigned to the manager are now allocated to the worker. Note that even
though the effect of increasing discretion is not monotone increasing, the effect is positive
throughout the intermediate interval. The firm receives higher payoffs in these states
when it chooses d
H
because decisions which were “misallocated” at the margin under d
L

are now being allocated to the decision-maker with an absolute advantage in those states.
The proof of Proposition 3 proceeds by first showing that, when potential choices of
d are restricted to one management regime, the state-contingent payoff function (denoted
h(s;d)
11
) has the single crossing property in (d;s). As shown in Figure 5, the function
h(s;d
H
) ÷h(s;d
L
) crosses zero once as a function of s, and from below. Recall that, in
Figure 5, each of the two potential discretion points are in the “meddlesome management”
regime. By restricting ourselves to one managerial regime, the monotone relationship
between worker discretion and u is ensured. This can be seen by the fact that, unless
there is a change in the management regime, h(s;d
H
) ÷h(s;d
L
) never changes sign in the
intermediate region.
12

Thus, even though h(s;d
H
) ÷h(s;d
L
) is neither continuous nor monotonic, h(s;d)
satisfies the single crossing property as long as we are restricted to one management
regime (as required by Proposition 3). If d
H
is preferred in a given state, it will also be

11
Where h(d; s) = t
W
(d; s)I
[0, d ]
+t
M
(d; s)I
[d ,1]
.
12
If both candidate levels of discretion lie in the hands-off management regime, then h(s; d
H
) ÷ h(s; d
L
) is
negative throughout the intermediate region, since increasing discretion allocates more states to the worker,
who is less qualified than the manager throughout the relevant region, by the definition of hands-off
management.
24

preferred for all higher states; thus, we can partition the states into two intervals, such that
d
L
yields higher payoffs in the low interval of states (Region A), while d
H
yields higher
payoffs in the high interval of states (Regions B and C).
To complete the discussion of Proposition 3, consider the effect of a shift in u for
the firm’s choice between d
H
and d
L
. As a result of an increase in u. Regions B and C
become more important relative to Region A. Thus, increasing u could not cause the
organization to switch from preferring d
H
to preferring d
L
. Note that we can not
guarantee that u universally raises the absolute returns to increasing discretion,
13
but this
is not required by the single crossing property; we simply show that increasing u does not
induce a reversal in the organization’s ranking of d
H
and d
L
when d
H
is preferred
initially.
14

Competing Management Regimes
In Proposition 3, we were restricted to the case where the organization compares
discretion points within the same regime. To see the potential violation of the single
crossing property when discretion points in different management regimes are analyzed,
consider Figure 6, where d
L
eS
MM
and d
H
eS
HO
. In Region B
1
, the firm’s payoffs
increase as a result of the increase in discretion , since in that region the worker is the
better decision-maker (meddlesome management); however, in Region B
2
, the manager is
the better decision-maker (hands-off management), and so the firm’s payoffs decrease in
those states as a result of the increase in discretion. The violation of the single crossing
property in this case implies that a potential non-monotonicity exists. The increase in u

13
If h(s; d
H
) ÷ h(s; d
L
) were monotonic in u. then any FOSD shift would increase the returns to discretion.
However, Figure 5 illustrates that, while h(s; d
H
) ÷ h(s; d
L
) crosses zero once, it is not monotonic in s for
the intermediate states. Thus, we must restrict more carefully the potential shifts in probability mass. For
more discussion of this, see Athey (1994).
14
Formally, we prove this by extending a result of Milgrom and Shannon (1994), showing that for any
payoff function h(d,s) which satisfies the weak single crossing property in (d,s) and any density f(s,u) which
satisfies the strict MLRP in (s,u), the expected value of h has the strict single crossing property in (d,u).
This lemma is of independent interest for comparative statics problems under uncertainty. While the
original statement of this lemma is given in the present paper, Athey (1994) considers such problems in
more detail. She shows that the strict MLRP is in fact a necessary condition for the strict single crossing
property of the objective function to hold for all state-dependent payoff functions with the weak single
crossing property.
25

increases the probability weight on Region B
2
relative to the probability weight on
Region B
1
, an effect which makes d
L
more attractive. Intuitively, the increase in u
decreases the expected benefits of choosing the hands-off management regime, where the
benefits are phrased in terms of allocating states to the agent is the better decision-maker
in those states. Without more structure, we cannot rule out the possibility that this effect
of “competing management regimes” might outweigh the positive interaction between
discretion and u which results from the increase in the weight on Region C relative to
Region A.
The case where the non-monotonicity becomes relevant is illustrated in Figure 7,
which depicts a scenario where there is a local optimum in each management regime. As
u is increased, the optimal level of discretion within each management regime is also
increased (as stated in Proposition 3). However, for u
L
, the global optimum lies in S
HO
,
while for u
H
the global optimum lies in S
MM
. In response to the change from u
L
to u
H
,
the firm chooses to “jump” down from the hands-off management regime to the
meddlesome management regime. In the next subsection, we identify conditions under
which such a jump is ruled out.
Conditions Which Ensure a Monotonic Relationship Between Discretion and u
An immediate corollary of Proposition 3 is that the non-monotonicity is ruled out if
the parameters of the problem are such that only one management regime is ever
(globally) optimal. Consider the case of one-sided congestion. Proposition 2 states that
the optimal management relationship will always be hands-off (respectively meddlesome)
in the case when t
d
W
= 0 (respectively t
d
M
= 0 ). Thus, one-sided congestion is sufficient
to ensure the monotone comparative static result:
Corollary 3.1. Under (A1), (A2), (A3), and one-sided congestion, optimal worker
discretion (d) is monotone nondecreasing in u.
26

More generally, we might expect the monotone relationship to hold in situations where
the effects of congestion on one agent (i.e., the manager) are much larger than the effects
of congestion on the other agent (i.e., the worker).
Our next result restricts the range of potential optima in a different way, namely by
imposing single-peakedness of the organization’s objective function:
Corollary 3.2. Assume (A1)-(A3). Further assume that H(d;u) is strictly quasi-concave.
Then optimal worker discretion (d) is monotone nondecreasing in u.
The proof of Corollary 3.2 is in the appendix. In order to understand the relationship
between Proposition 3 and Corollary 3.2, it is useful to return to the case when the firm
faces local optima in both management regimes, and its choice of discretion is
unrestricted. As discussed above, the non-monotonicity is only relevant when the
organization compares two discretion points from different management regimes as
potential optima. Recall that Figure 7 illustrates an example where there is a local
optimum in each management regime. However, if the objective function is strictly quasi-
concave, the problem of competing local optima, such as those illustrated in Figure 7,
cannot emerge.
We now turn to consider the economic environments in which we expect the
objective function to be strictly quasi-concave. A sufficient condition is that there are
diminishing returns to reducing the scope of decision-making:
t
dd
W
< 0 and t
dd
M
> 0 (A4)
Under (A4), the marginal cost of congestion increases as the scope of each agent’s
decision-making increases. For example, a worker with large amounts of discretion
suffers higher marginal congestion costs than one with a small amount of discretion. We
believe that this assumption is reasonable for many economic environments. (A4) is
sufficient to ensure that the objective function, H(d;u), is globally concave, as follows:
27

c
2
cd
2
H(d;u) =
c
cx
t
W
(x, d) ÷ t
M
(x, d)
| |
· f (x)
| |
x=d
+ f (d) ·
c
cx
t
W
(d, x) ÷ t
M
(d, x)
| |
x=d
*
+ t
dd
W
(s, d)· f (s) · ds
0
d
í
+ t
d
M
(s, d) · f (s)· ds
d
1
í
(5.1)
The first two terms of (5.1) are non-positive by assumptions (A1) and (A2), respectively,
while (A4) guarantees that the last term is strictly negative. Thus, (A4) is only a
sufficient condition for global concavity of the objective function. The next corollary
follows directly:
Corollary 3.3. Under (A1)-(A4), d is monotone nondecreasing in u.
An immediate consequence of Corollary 3.3 is that, for non-monotonicities to arise, there
must be increasing returns to reducing the scope of an agent’s decision-making in some
regions.
Interpretations
We have demonstrated that, under a general set of conditions, worker discretion
increases as the relative likelihood of highly ordered states increases. This insight is
useful for understanding issues associated with the organizational contexts that we have
been considering throughout the paper.
First, let us revisit the question of how nurse discretion should change in response to
changes in medical technology. The increasing complexity of medical procedures, along
with the introduction of sophisticated electronic monitoring devices, implies that the
treatment decision states where a physician’s expertise is needed occur relatively more
frequently. In our model, this change corresponds to an increase in the parameter u.
Thus, the scope of nurse discretion should increase in response to the observed changes in
the distribution of treatment decision states. Increasing nurse authority, i.e., allowing
nurses to prescribe non-narcotic drugs, is, in fact, widely advocated within the health care
policy community. As early as 1969, Victor Fuchs put forward arguments consistent with
our policy conclusion:

28

While most of the country goes around shaking its head about the doctor shortage, I am impressed
by the existence of considerable waste. The waste is evidence when you see so many physicians
spending so much of their time at tasks that could be performed as well or better by someone with
considerably shorter, more specialized training. The pediatrician providing well baby care, the
gynecologist attending normal delivery, internists treating common colds are just a few examples
of this phenomenon. (Fuchs, 1969, p. 407)
The monotone relationship between worker discretion and u also provides insight
into management by exception. Essentially, we are considering a situation in which, at
the old level of discretion, the frequency of exceptions has increased. The organization
accommodates this increase by “re-defining” an exception. The firm increases worker
discretion to conserve scarce managerial resources. Our framework cannot predict, in a
general way, whether the frequency of exceptions will go up or down; we simply know
that the optimal scope of decision authority moves in the same direction as the shift in
probability.
15

However, in the most general case, we cannot rule out the possibility that the two
management regimes will compete. In such cases, if we are interested in the change in
discretion which will result from an increase in u, and the organization of interest is
currently characterized by hands-off management, we must consider the possibility that
the organization will choose to switch regimes and thus reduce discretion. In such a case,
the effect of frequency of decision-making is unambiguous: managers make more
frequent decisions.
VI. Changes in Worker and Manager Effectiveness
In the previous sections, we focused on the organization’s choice of discretion,
exclusively. In reality, however, the choice of discretion is made within the context of
other choices regarding personnel management. In particular, organizations have some
influence over the decision-making qualities of their workers. We would like to

15
This is true because the frequency of worker decision-making is determined by the cumulative distribution
up to the discretion point. While this optimal choice of discretion is decreasing in u, the value of the
cumulative distribution function is also decreasing in u at every point. These two forces compete to shape
the effect on the frequency of decision-making.
29

understand how such choices interact with the optimal allocation of decisions. Thus, in
this section, we extend our model to allow the organization to invest directly in the
quality of the worker or the manager.
There are a number of ways that an organization can invest in worker and
managerial effectiveness. Training, the provision of computing resources, and the
redesign of work schedules are all examples of investments an organization can make in
agents’ decision-making abilities. In order to analyze these possibilities, here we allow
the organization to choose w (worker quality) and m (manager quality), which
parameterize the decision-making quality for the respective agents. We assume w and m
raise the respective benefit functions if workers and managers.
t
w
W
> 0 and t
m
M
> 0 (A5)
Each of these choices potentially involve costs. The costs of improving worker and
manager effectiveness, respectively c
W
(w;e) and c
M
(m;u), are subtracted from the
organization’s expected benefit function. We assume e and u parameterize the marginal
costs of improving worker and manager effectiveness:
c
we
W
(w;e) > 0 and c
mu
M
(m;u) > 0 (A6)
We have assumed that the cost functions are additively separable to incorporate the idea
that the cost of enhancing an agent’s effectiveness is independent of the scope of her
discretion; that is, quality improvements represent fixed costs to the organization.
At a first glance, it might seem that an improvement in the decision quality of an
agent should lead unambiguously to an increase in the scope of decision-making of that
agent, since an increase in decision quality raises the intrinsic effectiveness of the agent in
all states. However, the interaction of quality improvements with congestion has the
potential to create mitigating effects. More precisely, if an increase in quality causes a
large increase in the marginal cost of congestion (the case of t
dw
W
< 0 ), worker decision
quality improvements might decrease the returns to worker discretion.
However, since we are interested in improvements to an agent’s overall decision-
making ability, as opposed to training or resources which are directed at improving
30

performance in specific contingencies, there is no reason to believe that increasing
discretion lowers the return to worker quality in the inframarginal states. Nonetheless, we
do not need such a stringent assumption to guarantee that decision quality increases the
returns to the scope of decision-making assigned to a particular agent. Instead, we
assume the following as mild and interpretable sufficient conditions:
t
dw
W
(s,d,w)· f (s)
0
d
í
· ds > 0 and t
dm
M
(s,d,m) · f (s)
d
1
í
· dss 0 for all d (A7)
These assumptions guarantee that the expected value (over all states where the agent has
authority) of the marginal costs of congestion will fall as decision quality is raised.
Under the assumptions we have specified, the additional variables extend but do not
change the fundamental structure of the organization’s optimization problem. The
organization’s choice of worker and manager effectiveness are easily handled within the
contingency framework we have developed. To see this, observe that with the addition of
these new endogenous variables, the organization’s objective function becomes
H d,m,w;u,u, e
( )
= t
W
(s,d,w) · f (s;u)
0
d
í
· ds+ t
M
(s, d, m) ·
d
1
í
f (s;u) · ds
÷ c
W
(w;e) ÷ c
M
(m;u)

We now state our comparative static result.
Proposition 5. Assume (A1)-(A2), (A5)-(A7). Suppose there is either a decrease in the
marginal cost of improved worker effectiveness (e) or an increase in the marginal cost of
improved manager effectiveness (u). Then the optimal choices of discretion (d) and the
level of investment in worker effectiveness (w) are (weakly) higher, while the amount
invested in manager effectiveness (m) is (weakly) lower.
PROOF: To apply Milgrom and Shannon’s (1994) Monotonicity Theorem, we
show that H d,m,w;u,u,e
( ) is supermodular in (d,÷m,w) and has the single
crossing property in (d,÷m,w;÷u,÷e). We will show that H
dw
>0; that the other
relevant cross-partials are nonnegative follows analogously.
c
2
H
cdcw
= t
dw
W
(s, d,w) · f (s;u)
0
d
í
· ds+ t
w
W
(d, d,w)· f (d;u)
The first term is positive by (A7), while the second is positive by (A5).

31

The proposition reveals a structured interdependence between the three variables of
interest. The complementarities between the three variables allow us to tie the
movements of these variables together with respect to potential shifts in the exogenous
parameters. Moreover, establishing the interdependence of these choice variables has
allowed us to gain additional insight into the allocation of decision-making: the scope of
delegated decision-making is monotone in a number of organizational parameters
operating at the upper or lower level of the vertical hierarchy.
For example, different organizational forms might be optimal in economic
environments characterized by different levels of education and different wage rates in the
labor pool. An organization might choose high levels of worker discretion, high quality
workers, and relatively less qualified managers in an environment characterized by a
highly educated workforce (so that it is relatively inexpensive to hire and train quality
workers); in contrast, an organization which faces an uneducated labor pool might have to
incur higher training costs and wages to achieve the same level of quality in its workers,
and such an organization might then choose lower worker quality, lower worker
discretion, and higher managerial quality. This discussion is suggestive for comparisons
of organizations across regions or across time. For example, Henry Ford faced a very
different economic environment when he designed the Model T assembly line (where
workers had very little discretion) than the environment faced by Eiji Toyoda and Taiichi
Ohno in designing the Toyota production system in Japan (where workers have a large
amount of discretion).
Another way in which the organization can affect decision-making quality is by
varying the share of resources controlled by a given agent. We hypothesize that the more
resources available to an agent, the higher her relative decision-making effectiveness in
each state. As scarce organizational resources are put under the direct control of the
workers, the difference between the organization’s payoff under worker versus manager
decision-making increases. For example, machine maintenance workers are sometimes
grouped in a separate division reporting directly to central management. In contrast, a
production center with control over those resources would include at least some
32

maintenance personnel under the direct supervision of the worker in charge of the
production center. The choice of resource control has been identified as a critical
organization design variable in the management science literature.
16

Analytically, we can consider an increase in worker resource control to be analogous
to simultaneously improving worker quality and lowering manager quality. Thus, we can
analyze such a change using the logic from Proposition 5: worker resource control is
complementary with discretion. This result is consistent with the management adage:
“Responsibility and authority should be commensurate.”
Note that we have excluded the exogenous uncertainty parameter u from
Proposition 5. In general, it is not the case that the organization’s choice variables move
together in response to a change in u. To understand why u might have an ambiguous
effect, consider how the organization’s choice of w is affected by an increase in u . Since
worker-decision states are now less likely, the direct effect is a reduction in the marginal
benefit of worker effectiveness. If the parameters are such that discretion increases with
u, then the increase in discretion causes an indirect effect that raises the marginal benefit
from worker effectiveness. Without more structure, it is not clear which effect will
prevail.
VII. Interpretations and Extensions
In this paper, we examined the allocation of decisions within an organization which
faces an uncertain environment. In order to understand decision allocation, we
constructed a single-dimensional state space, in which higher-ordered states were
associated with higher relative effectiveness by high-level agents. Moving beyond the
previous literature (i.e., Marschak and Radner, 1972), we analyzed explicitly the potential
role of induced decision effectiveness, where an agent’s effectiveness is decreasing in the
scope of decision-making. We found that, when decisions are allocated optimally, there

16
See Galbraith (1973) and Chandler (1962).
33

exist states in which the agent who is allocated decision authority is not the “best”
decision-maker in these states. Instead, one agent’s decision scope is reduced in order to
avoid the high marginal costs of congestion.
These results allow for much deeper insight into one of the principal phenomenon
which motivated our inquiry, management by exception. We argue that the forces behind
management by exception are relatively low intrinsic advantages of managers in many
states; relatively high managerial congestion costs; and a downward sloping probability
distribution over states. High costs of managerial congestion have a further implication
as well: the worker will be allocated states in which she is actually less intrinsically
effective than the manager. We describe managers in this situation as “hands-off.”
In Marschak and Radner’s (1972) analysis of management by exception, the
manager is allocated those states where she is a better decision-maker. However, the
organization is designed so that these states arise infrequently (i.e., they are exceptions).
This formulation of the phenomenon is, at best, incomplete, in that it does not recognize
an important and fundamental difference between workers and managers -- competing
demands on managerial resources and time which lead them to face higher marginal
congestion costs.
In addition, analyzing congestion is a crucial step toward understanding the
comparative statics of this problem. For example, in the case of no congestion, the
distribution of states does not matter -- the relative frequency of decision-making plays no
role in the allocation decision. We show that congestion implies that the allocation
decision will generally depend on the distribution of states. Further, we were able to
show that, under general conditions, there exists a monotone relationship between the
scope of worker discretion and increases in the relative likelihood of higher ordered
states. An important force behind this result is the organization’s desire to minimize the
total costs of congestion. As probability mass is shifted toward high states, the expected
costs of managerial congestion increase, while the expected costs of worker congestion
decrease. This insight is important in understanding the forces that lead organizations to
increase the scope of worker decisions in more complex environments.
34

Of course, the analysis here could be extended. While we have identified a system
of organizational design variables which are complementary with discretion, we have not
characterized how the system changes with variables which determine the probability
distribution over states. Thus, our analysis should be viewed as a first step toward a
complete theory of state-contingent decision-making in organizations.
Finally, while stressing the importance of congestion, we have not modeled
explicitly the types of technologies and organizational contexts in which congestion is
likely to arise. In particular, we have only considered the allocation of decisions between
a fixed number of agents. A more complete analysis of decision-making in a vertical
hierarchy might consider issues such as the optimal span of control. It can be imagined
that, when each worker’s discretion is fixed, expanding the number of workers under a
manager’s control will increase the congestion experienced by the manager. This will
have implications for both the level of discretion per worker and the numbers of managers
in an organization. Hence, understanding how congestion affects decision allocation
could add additional insight into the forms of more complex hierarchical structures than
the simple vertical hierarchy considered in this paper.
17


17
This might be achieved by combining the analysis of this paper with some of the questions addressed in
work such as Sah and Stiglitz (1988) and Radner (1992).
35

Appendix: Proofs
Proof of Proposition 3
To apply the Monotonicity Theorem (Milgrom and Shannon, 1994, Theorem 4), we
must show that H has the single crossing property in (d;u) . The following lemma will
assist us.
Lemma 1. Suppose h(x;s) : X ×S ÷9 satisfies the weak single crossing property in
(x;s),
18
and that f (s;u) is a probability density function satisfying the strict MLRP.
Suppose further that for all ' x = ' ' x , h( ' x ;s) = h( ' ' x ;s) for some s with positive density.
Then H(x;u) = h(x;s)
s
í
f (s;u)ds has the strict single crossing property in (x;u).
19

The proof of Lemma 1 follows the proof of Proposition 4.
Now define
h(d;s) = t
W
(d;s)I
[0,d ]
+ t
M
(d;s)I
[d,1]

We will show that, within each management regime, h has the weak single crossing
property in (d;s). To see this, we need to show that for all d
H
> d
L
, if at some s,
t
W
(d
H
;s)I
[0,d
H
]
+ t
M
(d
H
;s)I
[d
H
,1]
> t
W
(d
L
;s)I
[0,d
L
]
+ t
M
(d
L
;s)I
[d
L
,1]
(A.1)
then inequality (A.1) will also be true for all ' s > s.
Consider three intervals: [0,d
L
], [d
L
,d
H
], and [d
H
,1]. In the interval [0,d
L
],
inequality (A.1) reduces to t
W
(d
H
;s) >t
W
(d
L
;s) , which is clearly always false. So we
can immediately restrict our attention to the interval [d
L
,1]. In the interval [d
H
,1], (A.1)
reduces to t
M
(d
H
;s) >t
M
(d
L
; s), which is clearly always true.
Thus, the problem reduces to establishing the weak single crossing property on
[d
L
,d
H
], where (A.1) reduces to t
M
(d
H
;s) >t
M
(d
L
; s). The analysis of this section
depends on whether d
H
,d
L
eS
MM
or d
H
,d
L
eS
HO
.
First consider case (i), where d
H
,d
L
eS
MM
. Then we know that
t
W
(d
H
,d
H
) >t
M
(d
H
,d
H
) >t
M
(d
H
,d
L
), since t
d
M
> 0 . Moreover, our definition of the

18
That is, for x >
'
x and s >
'
s , h( x;
'
s ) > h(
'
x ;
'
s ) implies h( x; s) > h(
'
x ; s) .
19
That is, for x >
'
x and u >
'
u , H(x;
'
u ) > H(
'
x ;
'
u ) implies H(x;u) > H(
'
x ;u) .
36

state space implies that t
M
(s,d) ÷t
W
(s, d) |s. Therefore, t
W
(s, d
H
) >t
M
(s, d
H
)
¬s e d
L
,d
H
| |
. Since t
d
W
s 0, t
W
(s, d
L
) >t
M
(s,d
H
) ¬s e d
L
,d
H
| |
.
Now consider case (ii), where d
H
,d
L
eS
HO
. Then we know that since t
d
W
s 0,
t
W
(d
L
, d
H
) st
W
(d
L
,d
L
) <t
M
(d
L
,d
L
). Since our definition of the state space implies that
t
M
(s,d) ÷t
W
(s, d) |s, then t
W
(s, d
H
) <t
M
(s, d
H
) ¬s e d
L
,d
H
| |
.
These arguments complete the proof that h has the weak single-crossing property in
(d;s). Our assumption that at least one agent experiences a congestion effect, together
with the assumption that f has full support, guarantees that for all d
L
,d
H
,
h(s,d
L
) = h(s,d
H
) for some s with positive density. Then since f has the strict MLRP, H
has the strict single-crossing property in (d;s) by Lemma 1. By Milgrom and Shannon
(1994), Theorem 4’, every selection from the set of optimizers is nondecreasing. Q.E.D.
Proof of Corollary 3.2
Consider any two arbitrary shift parameters, u
L
,u
H
eO, where u
L
<u
H
. Let
d
L
*
eargmax
deS
H(d;u
L
) and d
H
*
eargmax
deS
H(d;u
H
). Recall the definition of d
c
from
Section IV.
We will consider a change from u
L
to u
H
. There are two cases. First, suppose that
d
L
*
s d
c
. Then d
L
*
sd
H
*
, because either d
c
s d
H
*
, which implies that the result holds
trivially, or d
H
*
< d
c
, in which case Proposition 3 applies.
Second, consider d
L
*
> d
c
. We begin by ruling out the possibility that d
H
*
< d
c
.
Observe that argmax
d sd
c
H(d;u
L
) = d
c
by strict quasi-concavity, which in turn implies
that argmax
d sd
c
H(d;u
H
) = d
c
by Proposition 3. Knowing that d
H
*
> d
c
allows us to
restrict attention to that region without loss of generality; but then, Proposition 3 implies
that d
H
*
= argmax
d>d
c
H(d;u
H
) > argmax
d >d
c
H(d;u
L
) = d
L
*
. Q.E.D.
37

Proof of Lemma 1
First, we state a definition and a theorem that will assist with the proof.
Definition (Karlin, 1968). A real function g(s;u) is said to be strictly totally positive of
order 2 (STP-2) if for all s
1
< s
2
and u
1
<u
2
, we have:
g(s
1
;u
1
)g(s
2
;u
2
) ÷g(s
1
;u
2
)g(s
2
;u
1
) > 0.
Total positivity is a generalization of the MLRP. A parameterized density f (s;u) has the
strict MLRP if and only if it is STP-2.
Theorem 1 (Karlin, 1968). Define K(u) = k(s) f (s;u)ds
S
í
, where k ≠ 0 a.e. and u eO.
Suppose k changes sign from negative to positive once on the ordered set S and f (s;u) is
STP-2. Then K(u) changes sign at most once over O. If K does change sign, then u >
'
u
and K(
'
u ) > 0 imply K(u) >0.
Now suppose that h: X× S÷9 has the weak SCP and f : S×O÷9 is a
parameterized density with the strict MLRP. Fix x >
'
x and define
k(s) = h(x;s) ÷h(
'
x ;s) . Define K(u) = H(x;u) ÷ H(
'
x ;u) = k(s) f (s;u)ds
S
í
. Let
'
S = s eSk(s) = 0
{ }
. Note that f :
'
S ×O÷9 is STP-2. We have
K(u) = k(s) f (s;u)ds
' S
í
+ k(s) f (s;u)ds
S \ ' S
í
.
But the last term is zero so,
K(u) = k(s) f (s;u)ds
' S
í
.
If k(s) does not change sign on '
S , then K(u) does not change sign. If k(s) does
change since on S, it does so once from negative to positive since h(x;s) has the weak
SCP. Karlin’s theorem then implies that if K(u) changes sign, u >
'
u and K(
'
u ) > 0
imply K(u) >0. This is equivalent to H having the strict single crossing property in
(x;u).
38

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FIGURE 1: SIMPLE RULE FOR DECISION ALLOCATION









FIGURE 2: “MEDDLING MANAGERS”




s
1 0
Benefit

W
(s, d)

M
(s,d)
d





FIGURE 3: “HANDS OFF MANAGERS”




s
1 0
Benefit
S
MM
S
HO

W
(s, d
L
)

W
(s, d
H
)

M
(s, d
H
)

M
(s, d
L
)
d
L
d
H
d
c





FIGURE 4: UNIQUE CRITICAL DISCRETION POINT




s
1 0
Benefit
C
0
1 s
A B

M
(s, d
L
)

M
(s, d
H
)

W
(s, d
H
)

W
(s, d
L
)
d
L
d
H
d
L
d
H
h(d
H
, s)  h(d
L
, s)





FIGURE 5: NO REGIME SWITCHING









FIGURE 6: NON-MONOTONICITIES AND SWITCHING





s
1 0
Benefit
H(d,
H
)
H(d,
L
)
d(
L
)
d(
H
)
ˆ
d(
H
)
ˆ
d(
L
)
d
c





FIGURE 7: NON-CONCAVITY