A Dynamic Analysis of Product Innovation Based on Incentives and Manager's Behaviors

Abstract

This study investigates the design of incentive compensation and agents’ behaviors in product innovation. We develop a dynamic control model in which product quality improvement depends on both instantaneous investment and the manager’s innovative effort. Moreover, we consider the sensitivity of cash flow to product quality to characterize the firm’s heterogeneity and the specificity of each stage in product innovation. Our model shows that there are two consequences of an increase in the impact of product quality on corporate cash flow: (a) higher effectiveness of equity incentives; and (b) fewer incentives for managers. Further, although the manager who emphasizes innovation more is more likely to get equity by improving product quality, he reduces both the amount of and growth in his management effort; this leads to a lack of overall effort.

Keywords: Product innovation, effort, Incentives, Differential game model