The Effect of Uncertainty and Information Asymmetry on the Structure of Compensation Contracts: A Test of Competing Models

Abstract

This research note reports results of a laboratory experiment conducted as a follow-up investigation of an earlier study by Umanath, Ray and Campbell (Umanath, N. S., M. R. Ray, T. L. Campbell. 1993. The impact of perceived environmental uncertainty and perceived agent effectiveness on the composition of compensation contracts. Management Sci. (January) 32--45.). Here, we focus on a specific unexpected result of Umanath et al. who found evidence contradicting the theoretical prediction with respect to the impact of environmental uncertainty on the composition of compensation contracts. Umanath et al., in retrospect, offered an explanation for their unexpected finding based on an alternative theory under the same agency framework. Our results not only ratify the alternative explanation offered by Umanath et al., but also identify information symmetry/asymmetry as the contingent factor capable of reconciling the apparently contradicting predictions of the two agency-based theories used in this research.compensation plans, agency theory, incentive contracts, salary-incentive mix, information asymmetry

Experimental Evidence for Agency Models of Salesforce Compensation

“…Recall that the contradictory findings in the extant survey work could be attributed to the difficulty of measuring uncertainty conditional on effort. While the protocols used in prior experimental work (Umanath et al, 1993(Umanath et al, , 1996 obviated the measurement problem, they never implemented explicit functions. Hence, their results were not dispositive of the effort-output uncertainty effect.…”

“…For instance, two experimental studies (Umanath et. al 1993(Umanath et. al , 1996 have investigated the impact of effort−output uncertainty on compensation plans, but neither one manipulated utility functions and effort−output functions.…”

“…By implementing a fully specified AT model in each experimental condition, we are able to generate stronger probes of the theory. In contrast, extant experimental protocols either fail to implement an explicit AT model (e.g., Umanath et al 1993Umanath et al , 1996 or else fail to implement one or more factors of an explicitly specified AT model (e.g., Berg et al 1992).…”

Environmental cleanup of the nation's former nuclear weapons sites: Unprecedented public‐private challenges at the largest facilities

“…Unlike some project-specific types of risk, the allocation of financial risk is a ubiquitous element in contract design and forms the underpinnings of much of the existing theory on the subject. During the formulation of any agreement, there is a mutual understanding that regardless of the specific terms selected, there will always remain the possibility that the contractor will be unable to accomplish the desired tasks within the allotted time and cost budgets (Umanath et al, 1996).The decision as to how much of the resulting cost overrun should be assumed by each party in the event of such a variance is often thought to be a significant determining factor in the contract's overall effectiveness (Barron, 1972;Keisler et al, 2004;Scherer, 1964;Ward & Chapman, 1995).…”

Through the Eyes of the Beholder

“…Current compensation research suggests that the higher the perception of an individual's worth, the higher the proportion of noncontingent compensation in that individual's total compensation (Mehran, 1995;Rabin, 1994;Umanath, Ray and Campbell, 1996). Compensation structure refers to the level, mix and proportion of base salary (non-contingent compensation) and performance-contingent compensation (such as stock options, cash bonuses, etc).…”