Incomplete contract and divisional structures

In this paper we want to analyze the internal divisional structure within an organi-
zation in the framework of incomplete contract theory. We use the framework of Aghion
and Tirole (1997) and define the managerial control structure as \sequence of search".
A key feature of this paper which differentiate it from other works in the literature is
that we add add an ex post bargaining phase in which the managers can agree on the
project which maximize their joint private benefit. Our model shows the share of co-
operative surplus the managers can get from bargaining and their default pay off plays
a key role in determining their search effort. When there is no spill over effect between
the agents' effort, internal separation is always dominated by internal integration with
control right assigned to the agent (manager) with high interest congruence with the
principal (head quarter). When there are synergy effect and setup cost during integra-
tion, the principal need to consider the cost-benefit trade off as Riyanto (2000) suggests.
But more importantly, the optimal divisional structure depends heavily on whether the
bargaining is interest congruence enhancing (increase the interest congruence between
agents and the principal) or destroying (decrease the interest congruence).

JEL Classification: D23, L22
Key words: organizational form, divisional structure, incomplete contract, bargaining