Agent Discretion, Adverse Selection, and the Risk-Incentive Trade-Off

FTC Bureau of Economics Working Paper No. 255

31 Pages Posted: 5 May 2003

Date Written: December 10, 2002

Abstract

A basic tenet of incentive theory states that there is a trade-off between risk and incentives. By implication, greater variation in firm profits leads to a reduction in the use of profit sharing. Surprisingly, there is little empirical evidence for this relationship. This paper reexamines the difference between the theoretical prediction and the empirical evidence, and shows that the key is agent discretion over task choice. A theoretical model represents agent discretion as an adverse selection problem. This model guides the empirical analysis of contracts given to employees in British manufacturing firms. For employees without discretion over the tasks they perform, there is a negative relationship between variation in firm profits and the use of profit sharing. For employees with discretion, there is a positive relationship.

Keywords: Agency theory, principal-agent problem, incentives, profit sharing

JEL Classification: J33, D82, M52

Suggested Citation

Adams, Christopher, Agent Discretion, Adverse Selection, and the Risk-Incentive Trade-Off (December 10, 2002). FTC Bureau of Economics Working Paper No. 255, Available at SSRN: https://ssrn.com/abstract=387760 or http://dx.doi.org/10.2139/ssrn.387760

Christopher Adams (Contact Author)

CBO ( email )

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