Agent Discretion, Adverse Selection and the Risk-Incentive Trade-Off

A basic tenet of incentive theory states that there is a trade-off between risk and incentives. By implication, greater variation in firm profits leads to a reduction in the use of profit sharing. Surprisingly, there is little empirical evidence for this relationship. This paper reexamines the difference between the theoretical prediction and the empirical evidence, and shows that the key is agent discretion over task choice. A theoretical model represents agent discretion as an adverse selection problem. This model guides the empirical analysis of contracts given to employees in British manufacturing firms. For employees without discretion over the tasks they perform, there is a negative relationship between variation in firm profits and the use of profit sharing. For employees with discretion, there is a positive relationship.