Option-like Contracts For Innovation and Production

Abstract:     
We model how firms motivate their risk-averse managers to evaluate new investment projects as well as to manage assets-in-place. We first consider a two-agent model: an Innovator in charge of project adoption and a Producer in charge of production. The Innovator's effort produces better information on risky projects, but he may reject a good project in order to avoid risk. The Producer's effort increases the mean of firm value but he faces uncertainty in his productivity, due to the externality created by the new project. We examine the two agents' roles in the firm separately and also combine them in a Nash game. We derive optimal contracts for them and show that under mild conditions they exhibit convexity. We next demonstrate that when a single agent is assigned both tasks, his contract is in general convex, with the degree of convexity increasing in the agent's importance in managing the new project. We interpret the convexity in the optimal contracts as "option-like" compensation.

Number of Pages in PDF File: 45

JEL Classification: G33 to G31

working papers series