Multi-Divisional Structure and Innovation

Abstract

Theories of innovation tend to advocate flat versus hierarchical organizations. However, the bulk of R&D is done by large (and unavoidably hierarchical) firms, which we wouldn’t expect if they were severely disadvantaged. We propose a theory of innovation that both identifies an advantage for hierarchy and prescribes a decomposition into firm units that better exploits that advantage. We construct an interacting-agent model of the theory, which we then test in the banking industry. Our results are consistent with the model’s predictions. In particular, innovation increases in the heterogeneity in units’ knowledge as well as their geographic proximity. Interestingly once we account for decomposition, the contributions of headquarters are negative. In particular, innovation decreases with both system scale and the additional hierarchical level. This suggests headquarters more than offsets the potential disadvantages of hierarchy through the innovation mechanisms we propose.