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Uncertainty, Risk, and Incentives: Theory and Evidence

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  • Zhiguo He

    () (Booth School of Business, University of Chicago, Chicago, Illinois 60637)

  • Si Li

    () (School of Business and Economics, Wilfrid Laurier University, Waterloo, Ontario N2L 3C5, Canada; and PBC School of Finance, Tsinghua University, 100083 Beijing, China)

  • Bin Wei

    () (Board of Governors of the Federal Reserve System, Washington, DC 20551)

  • Jianfeng Yu

    () (Carlson School of Management, University of Minnesota, Minneapolis, Minnesota 55455)

Abstract

Uncertainty has qualitatively different implications than risk in studying executive incentives. We study the interplay between profitability uncertainty and moral hazard, where profitability is multiplicative with managerial effort. Investors who face greater uncertainty desire faster learning, and consequently offer higher managerial incentives to induce higher effort from the manager. In contrast to the standard negative risk-incentive trade-off, this “learning-by-doing” effect generates a positive relation between profitability uncertainty and incentives. We document empirical support for this prediction. This paper was accepted by Wei Jiang, finance.

Suggested Citation

  • Zhiguo He & Si Li & Bin Wei & Jianfeng Yu, 2014. "Uncertainty, Risk, and Incentives: Theory and Evidence," Management Science, INFORMS, vol. 60(1), pages 206-226, January.
  • Handle: RePEc:inm:ormnsc:v:60:y:2014:i:1:p:206-226
    DOI: 10.1287/mnsc.2013.1744
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    File URL: http://dx.doi.org/10.1287/mnsc.2013.1744
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    References listed on IDEAS

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    1. Wang, Huijun & Yan, Jinghua & Yu, Jianfeng, 2017. "Reference-dependent preferences and the risk–return trade-off," Journal of Financial Economics, Elsevier, vol. 123(2), pages 395-414.
    2. Shi, Jinchuan & Zhang, Xiaoqian, 2018. "How to explain corporate investment heterogeneity in China's new normal: Structural models with state-owned property rights," China Economic Review, Elsevier, vol. 50(C), pages 1-16.
    3. Zhiguo He & Bin Wei & Jianfeng Yu & Feng Gao, 2017. "Optimal Long-Term Contracting with Learning," Review of Financial Studies, Society for Financial Studies, vol. 30(6), pages 2006-2065.
    4. Peng, Lin & Röell, Ailsa A & Tang, Hongfei, 2016. "CEO Incentives: Measurement, Determinants, and Impact on Performance," CEPR Discussion Papers 11417, C.E.P.R. Discussion Papers.
    5. Zhihua Chen & Yanfei Lan & Ruiqing Zhao, 2018. "Impacts of risk attitude and outside option on compensation contracts under different information structures," Fuzzy Optimization and Decision Making, Springer, vol. 17(1), pages 13-47, March.
    6. Cintya Lanchimba & Josef Windsperger & Muriel Fadairo, 2018. "Entrepreneurial orientation, risk and incentives: the case of franchising," Small Business Economics, Springer, vol. 50(1), pages 163-180, January.
    7. Richardson, Vernon J. & Sanchez, Juan Manuel & Setia, Pankaj & Smith, Rodney, 2018. "Determinants and consequences of chief information officer equity incentives," International Journal of Accounting Information Systems, Elsevier, vol. 31(C), pages 37-57.
    8. Yue Chen & Sai-Ho Chung & Shu Guo, 2020. "Franchising contracts in fashion supply chain operations: models, practices, and real case study," Annals of Operations Research, Springer, vol. 291(1), pages 83-128, August.
    9. Pu Chen & Sanxi Li & Jianye Yan & Xundong Yin, 2016. "Moral hazard in innovation: the relationship between risk aversion and performance pay," Journal of Economics, Springer, vol. 118(1), pages 77-89, May.

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