Retention Contracts under Hidden Information

Abstract

This paper focuses on the utilization of retention contracts to screen and discipline managers in a context in which the council, board of directors, possesses incomplete information about the consequences of managers’ decisions. The analysis enlightens us on empire building, on the slight connection between achievement and firing, and describes concerns about the belief that low achievements result from bad managers. This paper analyzes a basic model to show the resulting dilemmas. The desire to screen managers to enhance the organization's future wellbeing motivates managers to show their credentials by becoming excessively active. The council can address this bias by firing a manager whose project is proven to ruin value. Moreover, the council can replace the manager if he has implemented a project, but its outcomes remain unobservable. Both decisions decrease the attraction to develop loss-generating projects. However, the dismissing decision on either ground will affect the council deduction that the expected competence of the incoming manager is lower than that of the dismissed manager. This study shows in which situation the selection option is preferred over the disciplining option using a pessimistic contract.