Corporate Governance, Managerial Compensation, and Disruptive Innovations

Abstract

Whether a manager leads the innovation efforts of a firm in line with shareholder preferences has a substantial impact on the firm's market value and growth. This in turn influences aggregate productivity growth and welfare. Using data on US public firms, we find that (i) firms with better corporate governance tend to adopt highly incentivized contracts rich in stock options and (ii) such contracts are more likely to lead to disruptive innovations -- patented inventions that are in the upper tail of the distribution in terms of quality and originality. We develop and estimate a new dynamic general equilibrium model of firm-level innovation with agency frictions and endogenous determination of executive contracts. The model is used to study the joint dynamics of corporate governance, managerial compensation, and disruptive innovations. Better corporate governance can reduce the influence of the manager in determination of the compensation structure. This leads to more incentivized contracts and boosts innovation, with substantial benefits for the shareholders as well as the broader economy through knowledge spillovers. Reducing agency frictions leads to an increase in long-run output growth, which translates into a significant welfare gain in consumption equivalent terms. An extended model with short-term earnings pressure on the manager reveals that short-termism only slightly dampens the gains from reducing manager influence; it is quantitatively less detrimental in comparison; and alleviating both frictions at the same time leads to amplified gains in growth and welfare.

Keywords: Agency frictions, corporate governance, innovation, managerial compensation, short-termism

JEL Classification: E20, G30, O40