Uncertainty and Contracting: A Theory of Consensus and Envy in Organizations

Abstract

We explore the impact of Knightian uncertainty on contracting within a multi-layered firm. We study a setting where, absent uncertainty, division managers should be paid based on their division performance, but not other divisions’performance. As uncertainty increases, division managers become more conservative (than company headquarters) about the prospects of their own division, diminishing e¤ort. Correspondingly, division managers become also relatively more positive about the prospects of others divisions within the firm, generating envy and discord in the organization. When uncertainty is large enough, headquarters grants a division manager a share of other divisions’ payoff to hedge uncertainty, thus instilling confidence and promoting a shared view (i.e., consensus) within the organization. Our model can explain the prevalence of equity-based incentive contracts in (young) firms with uncertain cash-‡ow prospects, and the prevalence of performance-based contracts in more mature and well-established firms.