Motivating Innovation with Misspecified Contracts

TL;DR

This paper introduces a principal-agent model where a principal guides an agent through a roadmap of outcome models, revealing how misspecification concerns can hinder innovation and lead to endogenous innovation cycles.

Contribution

It develops a new framework for understanding innovation incentives under model misspecification, highlighting the impact of dynamic and static contracting on innovation behavior.

Findings

Early success can cause the agent to lose motivation due to misspecification fears.

Innovation frequency decreases as misspecification increases, leading to endogenous cycles.

Diversifying the roadmap improves principal's profit by reducing epistemic risk.

Abstract

We propose a new principal-agent framework where a principal communicates a roadmap -- a set of plausible outcome models and a prior belief over them -- to guide an agent who is learning the value of innovation. The agent trusts the prior but fears that each model is misspecified (or incorrect). In dynamic contracting, we find an impossibility result: the agent may fall into a breakthrough trap, where early unexplained success can raise his misspecification concerns to the point that no contract can motivate him to continue innovating. We also obtain an upper bound on the frequency of innovative activity that tightens as the degree of misspecification increases, which then causes innovation cycles to emerge endogenously in the long run. In static contracting, we show that diversifying the roadmap increases the principal's profit by reducing the agent's exposure to idiosyncratic epistemic risk.