The Tenuous Trade‐off between Risk and Incentives

Abstract

Empirical work testing for a negative trade‐off between risk and incentives has not had much success: the data suggest a positive relationship between measures of uncertainty and incentives rather than the posited negative trade‐off. I argue that the existing literature fails to account for an important effect of uncertainty on incentives through the allocation of responsibility to employees. When workers operate in certain settings, firms are content to assign tasks to workers and monitor their inputs. By contrast, when the situation is more uncertain, they delegate responsibility to workers but, to constrain their discretion, base compensation on observed output.