Innovation Through Performance-Based Contracts: A Transaction Cost Economics and Agency Theory Perspective

Although incomplete contracts are generally viewed as inefficient governance mechanisms, some authors suggest that a specific type of incomplete contract, namely, the performance-based contract, fosters innovation. A performance-based contract is characterized by low term specificity (i.e. contractual incompleteness) and rewards being tied to performance. Based on an integration of transaction cost economics and agency theory we hypothesize how PBCs affect innovation. We argue that low term specificity, i.e., not stipulating how the partner should deliver the performance and which resources to use, enhances a partner's autonomy, which in turn fosters innovation. However, too low term specificity inhibits innovation. Furthermore, we state that tying rewards to performance positively affects innovation. This relationship is, however, negatively moderated by the partner's degree of risk-averseness.