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Title: Uncertainty and Contracting in Organizations

Author(s): David Dicks and Paolo Fulghieri

Publication Date: October 2020

Keyword(s): Ambiguity and incentive contracting

Programme Area(s): Financial Economics

Abstract: We study a multidivisional firm where headquarters are exposed to moral hazard by division managers under uncertainty (or "ambiguity") aversion. We show the aggregation and linearity results of Holmström and Milgrom (1987) hold in an environment with IID ambiguity, as in Chen and Epstein (2002). While uncertainty creates endogenous disagreement that aggravates moral hazard, by hedging uncertainty headquarters can 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. Optimal contracts involve exposure to other divisions even when division cash flows are uncorrelated and, with sufficient uncertainty, involve equity-based pay, even when division cash-flows are positively correlated. Our model helps explain the prevalence of equity-based incentive contracts and the rarity of relative performance contracts.

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Bibliographic Reference

Dicks, D and Fulghieri, P. 2020. 'Uncertainty and Contracting in Organizations'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=15378