Informing Adaptation under Booms and Busts
63 Pages Posted: 1 Jun 2016
Date Written: May 1, 2016
Leading employees to adapt to changing market conditions – e.g., increased competition or technological change – is an important concern for managers in many business situations. Insufficient adaptation may arise either because employees do not have the information necessary to adapt or because they are not sufficiently incentivized. This paper considers a contracting problem in which a principal is privately informed of market conditions and wants to induce an agent to choose the adaptive project that best fits these conditions. The contract plays a dual role in both motivating and informing the agent. Here, the principal faces a trade-off: A contract that reveals the market conditions fosters adaptation, but it may demotivate the agent. In a dynamic setting, the equilibrium contracts never fully reveal the market conditions, ultimately resulting in insufficient adaptation. My model predicts that adaptation will be ineffi- ciently delayed in booms but happen early in busts. Both cases exhibit organizational inertia and path-dependence: There is a tendency toward continuing old projects.
Keywords: adaptation, informed principal, incentive contract, commitment, inertia
JEL Classification: D23, J41, M52
Suggested Citation: Suggested Citation