Project Selection, Production, Uncertainty, and Incentives

51 Pages Posted: 19 Jan 2002

See all articles by John E. Core

John E. Core

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Jun Qian

Fanhai International School of Finance, Fudan University; University of Pennsylvania - Wharton Financial Institutions Center

Date Written: January 2002

Abstract

We model how a firm motivates a risk-averse CEO not only to exert productive effort but also to evaluate and to adopt new projects. Evaluation effort produces better information on risky projects, but the agent may reject a good project in order to avoid risk. Productive effort increases the mean of firm value but the agent faces uncertainty in his productivity due to the externality created by the new project. We examine the effect of uncertainty about the success of the new project on contract slope and convexity. The convexity in the contract protects the agent from uncertainty about the success of the new project, and the contract is more convex when uncertainty is greater. The contract slope encourages the agent to work on both tasks and to make the right project choice. We show conditions under which increases in uncertainty about the success of the new project cause increases in the contract slope. This positive relation between contract slope and uncertainty contrasts with the standard agency model's prediction of a decreasing relation. The features of the optimal contract are broadly consistent with prior empirical evidence on cross-sectional variation in CEO incentives. In addition our model suggests that there can be two groups of firms. The first group of firms has high uncertainty, and there is an increasing relation between risk and CEO incentives. The second group of firms has lower uncertainty, and there is the traditional decreasing relation between risk and CEO incentives.

Keywords: Risk and uncertainty; Project selection; Multi-task principal-agent problem; Optimal contract; Contract slope and convexity

JEL Classification: J30, J33, G32, L14, L22

Suggested Citation

Core, John E. and Qian, Jun, Project Selection, Production, Uncertainty, and Incentives (January 2002). Available at SSRN: https://ssrn.com/abstract=297461 or http://dx.doi.org/10.2139/ssrn.297461

John E. Core (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02138
United States

Jun Qian

Fanhai International School of Finance, Fudan University ( email )

Shanghai
China
86-21-63895501 (Phone)
86-21-62934572 (Fax)

HOME PAGE: http://www.fisf.fudan.edu.cn/show-65-69.html

University of Pennsylvania - Wharton Financial Institutions Center

2306 Steinberg Hall-Dietrich Hall
Philadelphia, PA 19104
United States

HOME PAGE: http://fic.wharton.upenn.edu/fic/

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