Uncertainty, Contracting, and Beliefs in Organizations

Abstract

We study the impact of uncertainty on optimal contracting in a multidivisional firm. Headquarters contracts with division managers to induce effort. Uncertainty creates endogenous disagreement, aggravating moral hazard. By hedging uncertainty, headquarters designs incentive contracts that reduce disagreement and lower incentive provision costs, thereby promoting effort. Because hedging uncertainty can conflict with hedging risk, optimal contracts differ from those in 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