Uncertainty, Contracting, and Beliefs in Organizations

70 Pages Posted: 9 Dec 2018 Last revised: 27 Jan 2022

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: January 14, 2022

Abstract

A multidivisional firm has headquarters exposed to moral hazard by division managers under uncertainty. We show the aggregation and linearity properties of Holmström and Milgrom (1987) hold under IID ambiguity of Chen and Epstein (2002). While uncertainty creates endogenous disagreement that aggravates moral hazard, by hedging uncertainty headquarters can design incentive contracts that reduce disagreement, lowering incentive provision costs and promoting 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.

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 (January 14, 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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