Restructuring Human Capital Theory: Investment Decisions Under the Effect of Innovation Probability

Abstract:     
This paper develops a simple principal-agent model to examine the effect of innovation and entrepreneurship on human capital investment. In this model, investing in human capital not only increases future productivity of the agent but also impacts the likelihood of producing an innovative idea. If the agent comes up with a firm-specific innovation, he searches for a financier who would support the start-up of a new venture before he negotiates the second period wage with the principal. However, if the agent cannot find an interested financier, he signals the innovative idea to the principal and shares it for a nominal fee alongside the second period wage they agree upon. Therefore, the probability of innovation creates both opportunity and threat for the principal whilst it introduces entrepreneurship as a possible outside option for the agent. When the threat (i.e., risk of agent departure) is substantially large, the principal prefers to hinder innovation by changing the skill financing offer. The results help explain why agents invest in firm-specific skills and why firms share the cost of general skill investment, both of which are counter to and build upon the findings of Becker (1962). Furthermore, I show that the enforcement of non-compete clause reduces the probability of innovation in equilibrium. Finally, the results suggest that incentive contracts increase both expected firm profitability and the probability of innovation. These findings are consistent with recent empirical evidence such as increases in wage, business start-ups, and patenting with well-developed venture capital markets and cohere with higher innovation rate as a result of incentive contracts.

Number of Pages in PDF File: 57

Keywords: skill investment, innovation, entrepreneurship, non-compete clause, incentive contracts

JEL Classification: J24, L26, O31, M52

working papers series