The first chapter established that markets can break down due to team production externalities, market power, and information asymmetry. These failures provide the theoretical justification for hierarchy. The analysis so far, however, has established only that hierarchy has the capacity to work ideally in the absence of team production externalities, market power, and information asymmetry. The same factors that promote market failure promote hierarchical failure.

As long as information about employee types is hidden, it is impossible for managers to say exactly what behaviors they expect from subordinates. Therefore, it is impossible to write the kind of joint forcing contract suggested by Holmstrom. Subordinates are left in a state of ambiguity that affords them the opportunity to shirk strategically, hiding behind a veil of ignorance about which team member, or which external shock, is responsible for unsatisfactory observed outcomes.

Hierarchical superiors are not just the victims of team production externalities and information asymmetries. Hierarchy, by its very nature, gives each hierarchical superior monopsony powers as “buyer” of team efforts. In piece-rate organizations, the incentive to lower piece rates to take advantage of this position is at odds with efficiency.