Uncertainty, Contracting, and Beliefs in Organizations

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.