Uncertainty, Contracting, and Beliefs in Organizations

Abstract

A multidivisional firm has headquarters exposed to moral hazard by division managers under uncertainty. Uncertainty creates endogenous disagreement aggravating moral hazard; by hedging uncertainty, headquarters 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. Our model helps explain the prevalence of equity-based incentive contracts and the rarity of relative performance contracts, especially in firms facing greater uncertainty. Finally, we show the aggregation and linearity properties of Holmström and Milgrom (1987) hold in a dynamic model under IID ambiguity of Chen and Epstein (2002).

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

JEL Classification: D81, D84, M12