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Preliminary: Comments Welcome

By George Baker and Bjorn Jorgensen

Abstract

We develop a simple agency model that helps explain the ambiguous logical and empirical connection between environmental uncertainty and incentive strength. Our model stresses that two kinds of uncertainty (which we label volatility and noise) are important in the determination of optimal incentive strength. We define noise as uncertainty to which the agent should not react by changing his actions, and volatility as uncertainty whose outcome does change the agent’s optimal action choice. We show that, consistent with standard agency theory, an increase in noise reduces optimal incentive strength. Our surprising new result is that an increase in volatility actually increases optimal incentive strength in most circumstances. We also show that, when effort is contractible, the optimal linear contract in the presence of noise is first best and puts no weight on output. However, in the presence of volatility the principal will use outputbased compensation in an optimal linear incentive contract. Our results shed light on, and are consistent with the “controllability principle, ” by which agents should not be held accountable for risks that are beyond their control, and should be held accountable for controllable risks. We would like to thank Luis Garicano and Canice Prendergast for their thoughtful comments, and participants in seminars at Columbia, Cornell, Syracuse and USC. Volatility, Noise, and Incentive

Topics: Preliminary, Comments Welcome
Year: 2003
OAI identifier: oai:CiteSeerX.psu:10.1.1.195.4084
Provided by: CiteSeerX
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