Uncertainty and Contracting in Organizations

52 Pages Posted: 9 Dec 2018 Last revised: 23 Oct 2020

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)

Multiple version iconThere are 2 versions of this paper

Date Written: October 15, 2020

Abstract

We study a multidivisional firm where headquarters are exposed to moral hazard by division managers under uncertainty (or "ambiguity") aversion. We show the aggregation and linearity results of Holmström and Milgrom (1987) hold in an environment with IID ambiguity, as in Chen and Epstein (2002). While uncertainty creates endogenous disagreement that aggravates moral hazard, by hedging uncertainty headquarters can 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. Optimal contracts involve exposure to other divisions even when division cash flows are uncorrelated and, with sufficient uncertainty, involve equity-based pay, even when division cash-flows are positively correlated. Our model helps explain the prevalence of equity-based incentive contracts and the rarity of relative performance contracts.

Keywords: Contracting, Organizations, Hierarchy, Uncertainty Aversion, Ambiguty Aversion

JEL Classification: D81, D84, M12

Suggested Citation

Dicks, David L. and Fulghieri, Paolo, Uncertainty and Contracting in Organizations (October 15, 2020). 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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