Uncertainty, Contracting, and Beliefs in Organizations

68 Pages Posted: 9 Dec 2018 Last revised: 25 Jan 2023

See all articles by David L. Dicks

David L. Dicks

Baylor University - Department of Finance, Insurance & Real Estate

Paolo Fulghieri

University of North Carolina Kenan-Flagler Business School; European Corporate Governance Institute (ECGI)

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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

Dicks, David L. and Fulghieri, Paolo, Uncertainty, Contracting, and Beliefs in Organizations (December 15, 2022). Kenan Institute of Private Enterprise Research Paper No. 19-1, European Corporate Governance Institute – Finance Working Paper 704/2020, Available at SSRN: https://ssrn.com/abstract=3285458 or http://dx.doi.org/10.2139/ssrn.3285458

David L. Dicks (Contact Author)

Baylor University - Department of Finance, Insurance & Real Estate ( email )

P.O. Box 98004
Waco, TX 76798-8004
United States

Paolo Fulghieri

University of North Carolina Kenan-Flagler Business School ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

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