Optimal assignment of principalship in teams

This paper investigates the optimal assignment of principalship in teams. We formalize a theory of the firm pioneered by Alchian and Demsetz [Am. Econ. Rev. 62 (1972) 777] using an approach in the spirit of Grossman and Hart [J. Pol. Econ. 94 (1986) 691]. Our theory makes a distinction between production effort and monitoring effort. When it is costly to sign contracts on efforts, it may be optimal to let one party purchase the rights to monitor and to direct, and claim full residual. Principalship is the purchase of these rights. These rights are limited residual rights of control over actions. We have confirmed Alchian and Demsetz’s celeberated conjecture that residual claims should match residual control. We have also explored how the optimal assignment of principalship and partnership depends on the interaction between each member’s importance in production, the effectiveness of monitoring and the degree of teamwork. © 2001 Elsevier Science B.V. All rights reserved. JEL classification: D2; D8; L2