Instructions and Incentives in Organizations

Abstract

We propose a new perspective on organizations, emphasizing the role of instructions in providing incentives. We examine a conflict of interest between a principal and agent over the course of action in an organization. Instructions provide information to the agent, lowering the agent's cost of execution, thus steering him towards the organization's preferred course. But less informative instructions are an effective incentive tool only when the agent is sufficiently risk averse. Consequently, hiring a risk averse agent can be optimal. The model yields a rich set of observed organizational configurations based on instructions, risk preferences of agents, and incentive pay.