Motivating Innovation

Motivating Innovation

Abstract: optimal incentive scheme that motivates innovation consists of:  

+ substantial tolerance for early failure

+ reward for long-term success

+ commitment to a long-term compensation plan

+ job security

+ timely feedback on performance

How to structure incentives when the principal needs to motivate the agent to be more innovative?

• Incentives schemes that motivate innovation = structured differently from standard pay-for performance schemes

Executive compensation’s optimal contract can be a combination of:

+ stock options with long vesting periods, option repricing, golden parachutes

(brings on tolerance for early failure and reward for long-term success)

+ managerial entrenchment

(gives job security)

• Criticized because these protect/reward the manager after poor performance!

Process of innovation: using Bayesian decision models (known as bandit problems)

        + in bandit problems: the agent is uncertain about the true distribution of payoffs of the available actions; innovation is the discovery of actions that are superior to previously known actions

        + central concern: tension between the exploration of new untested actions and the exploitation of well-known actions

• exploration: reveals information about potentially superior actions but is also likely to waste time with inferior actions
• exploitation: ensures reasonable payoffs, but may prevent discovery of superior actions

• study the incentives for exploration and exploitation by embedding a bandit problem into a principal principal-agent framework

The model: 2 periods and 2 possible outcomes in each period (success or failure)

        + each period: agent can choose between exploiting or exploring

• costless: no conflict of interest between principal and agent

• two-armed bandit problem model

• exploration = extremely costly:

• standard principal-agent model
• principal must motivate agent to exert effort
• incorporates tension between exploration and exploitation, and between working and shirking in standard principal-agent models

Optimal contracts:

        + motivate exploitation: similar to standard pay-for-performance contracts

        + motivate exploration: exhibits substantial tolerance for early failures and reward long-term success

Threat of termination:

        + excessive termination = optimal to motivate exploitation

        + effects of termination = ambiguous on exploration