Incentives and the Nature of Uncertainty

Abstract

In the U.S., almost half of all private sector employees receive stock options or are otherwise claimants to part of the firm’s profit. This constitutes a three-folded puzzle: If profit participation is a small fraction of the worker’s overall compensation, why does it provide the worker with sufficient incentives? But if profit participation is a large fraction of the worker’s overall compensation, why is it optimal for the firm to compensate a typically risk-averse worker in this manner? Finally, if profit participation with small or large fractions of compensation is optimal for some workers, why is it not optimal for all workers? In this paper, I present a model of optimal firm-worker contracts that distinguishes two kinds of uncertainty: external and state uncertainty. External uncertainty is the uncertainty of the value created by a known optimal action, whereas state uncertainty reflects ex-ante uncertainty about the optimal action. I show first that profit participation is only desirable if state uncertainty is sufficiently large. Second, profit participation only needs to compensate workers for the differential in effort that different actions require; not for the total effort itself. I characterize the optimal profit participation scheme given the magnitude of external and state uncertainty and derive testable hypotheses.