Working Paper: CEPR ID: DP15378
Authors: David Dicks; Paolo Fulghieri
Abstract: We examine a multidivisional firm with 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). Due to uncertainty aversion, agents' beliefs depend endogenously on their exposure to uncertainty, either for their position in the organization (hierarchical exposure) or contracts (contractual exposure). Incentive contracts, by loading primarily on division cash-flow, lead division managers to be more conservative than headquarters, aggravating moral-hazard. By hedging uncertainty, headquarters design contracts that reduce disagreement, lower incentive provision costs, promoting effort. Because hedging uncertainty interacts 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 compensation.
Keywords: ambiguity; incentive contracting
JEL Codes: No JEL codes provided
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| exposure to uncertainty (D81) | beliefs of division managers (M54) |
| beliefs of division managers (M54) | effort levels of division managers (M54) |
| design of contracts (K12) | beliefs of division managers (M54) |
| design of contracts (K12) | effort levels of division managers (M54) |
| exposure to uncertainty (D81) | effort levels of division managers (M54) |