Information Externalities, Underinvestment, and Organizational Remedies

We examine the interaction between inter- and intradivisional learning and organizational design. In both periods of the model, managers make investment decisions. Innovation is costly because the expected cashflows associated with innovation are lower than expected cashflows of the status quo. However, first-period innovation produces valuable information about the probability of success of second-period innovation. Interdivisional learning, or the utilization by one division of information from another division's innovation, may lead to underinvestment, suggesting an often overlooked cost associated with decentralization in horizontally integrated firms. We explore ways for the principal to alter information flows to increase the investment efficiency through accounting systems, organizational structure, and horizontal disintegration.