Optimal Delegation

How should a principal delegate a task to an agent? This paper studies the choice of an agent's discretion as a contracting problem. We show that the agent's freedom of action can be used as an effective incentive device: the agent's initiative is determined by the discretion he has in decision making. Due to this incentive effect the relationship between the severity of the conflict of principal's and agent's interests and the agent's optimal discretion in decision making is potentially non-monotonic: it may be optimal to curtail a subordinate's authority over decision making even if there are no conflicting interests concerning that decision. Our theory provides a rationale for commonly observed phenomena such as ''demanding clear statements'' from advisors or ''imposing an innovation bias'' on an organizational structure.