Task Complexity and Incentive Contracting - An Empirical Investigation

Abstract

We explore the relation between task complexity, delegation, and incentive compensation. Conventional agency theory posits that task complexity increases the noise in performance measures and is hence associated with lower incentive compensation. However, Prendergast (2002) argues that task complexity increases the value of the manager's specific knowledge and increases the value of delegation and commensurately, the need to use incentive compensation. We use data from 145 for-profit hospitals to test these competing theories and explore outsourcing as an alternative to managerial delegation. We define delegation as the range of activities overseen by the manager. Holding the noise of performance measures constant, if outsourcing is a more efficient response to increases in task complexity, then task complexity should increase outsourcing and consequently decrease delegation, and thereby decrease the need for incentive compensation. Our empirical results support these predictions. First, we find the expected positive effect of task complexity on performance measure noise. Second, using two-stage least squares (2SLS) we find that delegation is positively associated the use of incentive compensation. Finally, we find that task complexity is negatively associated with delegation, consistent with the use of outsourcing as a more efficient mechanism to deal with contracting in the presence of task complexity.