Uncertainty, Contracting, and Beliefs in Organizations
70 Pages Posted: 9 Dec 2018 Last revised: 27 Jan 2022
Date Written: January 14, 2022
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: Suggested Citation