Impacts of risk attitude and outside option on compensation contracts under different information structures

We consider an agency problem where a firm (she) hires a manager (he) who has related managerial expertise to implement a new project. The manager’s managerial expertise is his private information and characterized as an uncertain variable. The revenue brought about by the project in the future is also assumed to be uncertain. In light of these challenges, this paper investigates the impacts of the manager’s risk attitude and the type-and-effort dependent outside option on the optimal compensation contracts under different information structures. Through developing the manager’s decision criterion based on his risk attitude instead of the expected-utility-maximization criterion, we find that, if the manager is conservative and the outside option’s revenue uncertainty is sufficiently high, the optimal commission rate will be distorted upwards under asymmetric managerial expertise information compared with that under symmetric managerial expertise information. Our analysis also confirms that the existence of a type-and-effort dependent outside option distorts up the compensation structure tailored at a fixed outside option. We further show that, comparing with the setting of a fixed outside option when the manager is aggressive, the presence of a type-and-effort dependent outside option results in a surprising phenomenon that the manager’s private information makes no distortion of the firm’s profit.