Uncertainty, Risk, and Incentives: Theory and Evidence
38 Pages Posted: 17 Mar 2012 Last revised: 24 Feb 2013
Date Written: January 15, 2012
Uncertainty has qualitatively different implications than risk in studying executive incentives. We study the interplay between profitability uncertainty and moral hazard, where profitability is multiplicative with the managerial effort. Investors who face greater uncertainty desire faster learning, and consequently offer higher managerial incentives to induce higher effort from the manager. In contrast to the standard negative risk-incentive tradeoff, this 'learning-by-doing' effect generates a positive relation between profitability uncertainty and incentives. We document empirical support for this prediction.
Keywords: executive compensation, optimal contracting, learning, uncertainty, risk-incentive trade-off
JEL Classification: G30, G34, J33
Suggested Citation: Suggested Citation