Optimal Contracting with Moral Hazard and Cascading


Posted: 28 May 1998


In this paper I identify optimal incentive contracts for managers of firms competing in the product market. Such firms often confront similar decisions and uncertainties. Managers can improve decision quality by generating private signals through costly effort. However, since signals are likely to be correlated, firms that decide later get additional information from the actions of earlier firms. This impacts effort choice. Decision quality is also affected if later managers disregard their own signals and blindly imitate preceding decisions. In a competitive environment, such cascading hurts profits. Contracts that solve both moral hazard and cascading problems typically put more weight on firm profits, making them expensive. Contracts with more weight on decision quality are less expensive but result in cascades. Shareholders choose contracts that maximize their net surplus. This results in testable implications about which industries may have more convergence in investment choices, greater pay-for-profit sensitivity, larger differences in observed contracts, more innovation, larger-sized firms, and potential for over-compensation.

JEL Classification: D81, D82, G31, G32

Suggested Citation

Khanna, Naveen, Optimal Contracting with Moral Hazard and Cascading. REVIEW OF FINANCIAL STUDIES VOLUME 11, ISSUE 3, Available at SSRN: https://ssrn.com/abstract=92948

Naveen Khanna (Contact Author)

Michigan State University ( email )

East Lansing, MI 48824-1121
United States
517-353-1853 (Phone)
517-432-1080 (Fax)

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