Information Technology and Optimal Firm Structure

In this paper I use a principal-agent framework to explore the relation between the hierarchical structure of firms and the accounting information technologies available to them. I allow the principal to choose the number of layers in the firm, the number of agents in each layer, and the quantity and quality of information in the firm (subject to the available information technology). Alternative information technologies are characterized by their monitoring efficiency, the impact of control reduction on information quality and the returns on monitoring effort. I find that demand for a layer of supervisors exists only for a limited set of parameters. Furthermore, only in a few extreme cases do the benefits of additional layers of supervisors outweigh the costs. Obviously, there are reasons other than supervision for firms to use hierarchical structure; hence, my results demonstrate that from an information gathering perspective, in many cases, the required information rent associated with a hierarchical structure may outweigh its benefit, and in this respect "flatter" organizations are optimal. Structural changes in the economy that make monitoring more difficult might increase the information rent in a hierarchy. Hence, the analysis in this paper may help explain the recent trend towards "flatter" organizational structures.