On the Trade-Off between Risk and Compensation

Abstract:     
In a principal agent setting I show that the trade-off between risk and compensation is not monotonic. It is always beneficial for a company to offer a pay-per-performance contract that entails an additional performance measure that imposes more risk to the agent. The agent benefits from the imposition only if he is sufficiently risk averse and/or the additional performance measure is risky enough. The paper sheds light on the mixed results on the association between risk and incentives, and also offers some insight on organizational policies on incentives and communication.

Keywords: Incentives, risk, uncertainty, standard agency model

JEL Classification: J33, J41, G32, L22

Accepted Paper Series