• *We would like to thank Ramon Caminal, Melvyn Coles, Kai Uwe Kühn, Carmen Matutes, and Martin Perry for helpful discussions and seminar audiences at City University, Cornell University, Factultés Notre Dame de la Paix at Namur, Northwestern University, Purdue University, Rutgers University, University of Newcastle, Universitat Pompeu Fabra and Washington University for valuable comments. Pierre Régibeau gratefully acknowledges financial help from the European Community under the Human Capital Mobility Program.


This paper studies the choice of organizational forms in a multi-task principal-agent model. We compare a functional organization in which the firm is organized into functional departments such as marketing and R&D to a product-based organization in which the firm is organized into product lines. Managers' compensation can be based on noisy measures of product-line profits. Measures of a functional area's contribution to total profits are not available, however. This effect favors the product organization. However, if there are significant asymmetries between functional area contributions to organizational success and cross-product externalities within functions, organizing along functional lines may dominate the product organization. The functional organization can also dominate when a function is characterized by strong externalities while the other is not.