Optimal incentives for managerial innovation

An agency model is proposed that identifies the optimal executive compensation scheme for a business where the owner's delegation of investment decision-making to the manager gives rise to a two-dimensional moral hazard problem relating to the levels of managerial effort and innovation, respectively. The optimal executive compensation structure is shown to depend on which of the two moral hazard dimensions predominates, thus accounting for the coexistence in the real-world of bonus-like plans with different convexity degrees and risk-reward schemes. The model also identifies the conditions under which the efficient investment policy involves high innovation, highlighting the role played by the delegation of investment decisions in the coexistence of high-tech and more traditional industries.