Uncertainty, Contracting, and Beliefs in Organizations
Kenan Institute of Private Enterprise Research Paper No. 19-1
European Corporate Governance Institute – Finance Working Paper 704/2020
68 Pages Posted: 9 Dec 2018 Last revised: 25 Jan 2023
There are 2 versions of this paper
Uncertainty, Contracting, and Beliefs in Organizations
Uncertainty, Contracting, and Beliefs in Organizations
Date Written: December 15, 2022
Abstract
A multidivisional firm has headquarters exposed to moral hazard by division managers under uncertainty. Uncertainty creates endogenous disagreement aggravating moral hazard; by hedging uncertainty, headquarters design incentive contracts that reduce disagreement, lower incentive provision costs and promote effort. Because hedging uncertainty can conflict with hedging risk, optimal contracts differ from standard principal-agent models. Our model helps explain the prevalence of equity-based incentive contracts and the rarity of relative performance contracts, especially in firms facing greater uncertainty. Finally, we show the aggregation and linearity properties of Holmström and Milgrom (1987) hold in a dynamic model under IID ambiguity of Chen and Epstein (2002).
Keywords: Contracting, Organizations, Hierarchy, Uncertainty Aversion, Ambiguty Aversion
JEL Classification: D81, D84, M12
Suggested Citation: Suggested Citation