Market Conditions for an Organizational Form: The Three-Layer Corporate System

Abstract

An organization typically consists of a hierarchy system and a set of contracts. The three-layer system with owners, managers and workers coupled with a linear contract for managers is the choice of organizational form in modern corporations. Then, under what conditions is such a system efficient? More specifically, under what conditions is a linear contract efficient in a multi-layer corporate system? This paper presents such a model under perfect information. Instead of emphasizing the role of information, we focus on the role of market discipline for an organization. It turns out that efficient markets are crucial for this system to be efficient. Specifically, this system is efficient if there is (1) a competitive managerial labor market, (2) a competent manager, and (3) a competitive workers' labor market. The assumption of perfect information allows us to identify a potential structural problem in a hierarchy system without being entangled with information problems in an organization, but it may limit our model's direct applications to real-world organizations. However, such a model provides us a unique understanding of the role of market in an organization governed by linear contracts.