Uncertainty, Delegation and Incentives

How does imperfect contractibility of preferences in‡uence the governance of a contractual relationship? We analyze a two-party decision-making problem where the optimal decision is unknown at the time of contracting. In consequence, instead of contracting on the decision directly, the parties need to design a contract that will induce good decision-making in the future. We examine how environmental uncertainty, quality of available performance measures and interim access to information in‡uence the joint determination of the allocation of authority, use of performance pay and direct controls. We use the results from the model to cast light on (i) the con‡icting empirical evidence on the risk-incentives tradeo¤ found in work on executive compensation and franchising, (ii) complementarities in organizational design and (iii) the determinants of the choice to delegate.