Uncertainty, Delegation and Incentives

Abstract

How does imperfect contractibility of preferences influence the governance of a contractual relationship? We analyze a two-party decision-making problem where the optimal decision is unknown at the time of contracting. In consequence, instead of contracting on the decision directly, the parties need to design a contract that will induce good decision-making in the future. We examine how environmental uncertainty, quality of available performance measures and interim access to information influence the joint determination of the allocation of authority, use of performance pay and direct controls. We use the results from the model to cast light on (i) the conflicting empirical evidence on the risk-incentives tradeoff found in work on executive compensation and franchising, (ii) complementarities in organizational design and (iii) determinants of the choice to delegate.