Incentives and performance in the presence of wealth effects and endogenous risk

On the (Mis)Use of Wealth as a Proxy for Risk Aversion

“…In most of the literature, the ex ante wealth levels are implicitly set equal to zero to focus on the contract itself, 7 We allow for the possibility that both the principal and the agent are risk averse based on Holt and Laury's (2002) conclusion that "clear evidence for risk aversion, even with low stakes, suggests the potential danger of analyzing behavior under the simplifying assumption of risk neutrality." but our focus on wealth effects requires that they be incorporated in the utility function, as in Menezes and Hanson (1970) and Zeckhauser and Keeler (1970), and more recently in Meyer and Meyer (2005) and Guo and Ou-Yang (2006). 8 Finally, the agent's reservation utility isŪ = U(z a ), which accounts for the fact that the agent receives his ex ante wealth regardless of whether he participates in the contract or not.…”

Managerial ownership and performance

“…Aggarwal and Samwick (2006) suggest that a simple optimal contracting framework, ignoring corporate investment, is insufficient to control for the existence of the entrenchment effect of managerial ownership. Finally, Guo and Ou-Yang (2006) endogenize the corporate risk by proposing an expanded negative exponential utility framework, under which the agent can manage both the mean and the risk of an output. Within this framework, they show that the relationship between incentives (e.g., ownership) and firm value can be either positive or negative.…”

Agency and Anxiety

“…Although Casadesus‐Masanell (2004) and Oyer (2004) provide important alternative explanations for violations of the informativeness principle and Guo and Ou‐Yang (2006) and Prendergast (2002a, b) for the risk–reward tradeoff, an advantage of our approach is that it addresses all of the above issues within a single theoretical framework. As Rosen (2008) emphasizes, the common intuition underlying all our results is that one of the central tasks of management is to foster an optimal amount of tension in the workplace.…”

“…Alternative explanations include Guo and Ou‐Yang (2006) mentioned previously and Prendergast (2002a), who shows that the principal prefers delegation and incentives in unstable environments where she is uncertain about which action the agent should choose. In contrast, the principal prefers authority and monitoring in stable environments where there is more certainty about the appropriate action, so there is a positive relationship between incentives and risk.…”