by Gustavo Manso
Motivating innovation is an important concern in many incentive problems. For example, shareholders of large corporations often need to motivate managers to pursue more innovative business strategies. This paper shows that incentive schemes that motivate innovation are fundamentally different from standard pay-for-performance incentive schemes used to induce effort or to avoid tunneling. The optimal incentive scheme that motivates innovation exhibits substantial tolerance (or even reward) for early failure and reward for long-term success. Moreover, even though the principal can terminate the agent, inefficient continuation may be optimal to motivate innovation.
Finally, commitment to a long-term compensation plan and timely feedback on performance are essential ingredients to motivate innovation. In the context of managerial compensation, the optimal incentive scheme that motivates innovation can be implemented via a combination of stock options with long vesting periods, option repricing, golden parachutes, and managerial entrenchment.
February 25, 2010