Knowledge that Transforms

I study optimal managerial contracts in two contracting environments. When the investment return is contractible, an optimal contract combines a base salary, golden parachute, and bonus. When the return is not contractible, two types of optimal contracts are studied: a contract with restricted stock and a contract with stock options. These three types of contracts are equivalent: they implement the same outcome and lead to the same expected payoff for the manager, implying that the choice of contractual form is irrelevant in the environment I study. I suggest directions of research for the relevance of different contractual forms.

This article considers a model where the agent is uncertain about his innate ability and instead makes an inference from others’ (namely, the principal’s) perception, as often emphasized in the psychology literature. When the principal has superior knowledge about the agent’s productivity than the agent himself, the principal has an incentive to use promotions strategically to boost the agent’s self‐confidence. Within this framework the optimal promotion policy depends not only on the agent’s current expected ability type but also on the history of his previous job assignments. We use this fact to explain why we rarely observe demotions in organizations.