Rules vs. Discretion in Organizations

Whether to set managerial rules or allow managerial discretion is a key issue in organizations. In this paper, we investigate the boundaries between rules and discretion in the firm. Using an incomplete contract approach, we differentiate between projects that are more efficiently managed under rules and those that are more efficiently managed under discretion. Our main finding is that for conservative projects with low expenditures and balanced expenditure/quality ratios, rules are more efficient than discretion; for other projects, discretion is efficient. We also find that (1) rules offer better incentives; (2) discretion works better for risky projects; (3) whenever discretion is efficient, rules are equally efficient; and (4) the profit share to the manager is independent of her decision-making rights (separation of income and control rights).