The Tenuous Tradeoff between Risk and Incentives

Abstract

Empirical work testing for a negative tradeoff between risk and incentives, a cornerstone of agency theory, has not had much success. Indeed, the data seem to suggest a positive relationship between measures of uncertainty and incentives, rather than the posited negative tradeoff. I argue that the existing literature fails to account for an important effect of uncertainty on incentives through the allocation of responsibility to employees. When workers operate in certain settings, the activities that they should engage in are well known, and firms are content to assign tasks to workers and monitor their inputs. By contrast, when the situation is more uncertain, firms know less about how workers should be spending their time. As a result, the delegate responsibility to workers but, to constraint heir discretion, base compensation on observed output. Hence, uncertainty and output-based pay are positively related. I argue that parts of the existing empirical literature are better explained through this lens than with the standard model.