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Uncertainty, Contracting, and Beliefs in Organizations

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  • David L Dicks
  • Paolo Fulghieri

Abstract

We study the impact of uncertainty on optimal contracting in a multidivisional firm. Headquarters contract with division managers to induce effort. Uncertainty creates endogenous disagreement, thereby aggravating moral hazard. By hedging uncertainty, headquarters design incentive contracts that reduce disagreement and lower incentive provision costs, thereby promoting effort. Because hedging uncertainty can conflict 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 contracts, especially in firms facing greater uncertainty.

Suggested Citation

  • David L Dicks & Paolo Fulghieri, 2025. "Uncertainty, Contracting, and Beliefs in Organizations," The Review of Financial Studies, Society for Financial Studies, vol. 38(7), pages 2182-2225.
    • Handle: RePEc:oup:rfinst:v:38:y:2025:i:7:p:2182-2225.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhaf005
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    More about this item

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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