Information Production and Capital Allocation: Decentralized vs. Hierarchical Firms

Abstract

This paper assesses different organizational forms in terms of their ability to generate information about investment projects and allocate capital to these projects efficiently. A decentralized approach - with small, single-manager firms - is most likely to be attractive when information about individual projects is "soft" and cannot be credibly transmitted. Moreover, holding fixed firm size, soft information also favors flatter organizations with fewer layers of management. In contrast, large hierarchical firms with multiple layers of management are at a comparative advantage when information can be costlessly "hardened" and passed along within the hierarchy. As a concrete application of the theory, the paper discusses the consequences of consolidation in the banking industry. It has been documented that when large banks acquire small banks, there is a pronounced decline in lending to small businesses. To the extent that small-business lending relies heavily on soft information, this is exactly what the theory would lead one to expect.