Uncertainty and Contracting in Organizations

Uncertainty and Contracting in Organizations

David Dicks, Paolo Fulghieri

Series number :

Serial Number: 
704/2020

Date posted :

October 19 2020

Last revised :

October 25 2020
SSRN Share

Keywords

  • contracting • 
  • Organizations • 
  • Hierarchy • 
  • Uncertainty Aversion • 
  • Ambiguty Aversion

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.

Authors

Real name:
David Dicks