Abstract

The conventional pay-for-performance schemes are designed for inspirit agents to exert effort. Manso structured incentive schemes to motivate innovation in a two-period production process. However, his solution is just dependent on the probability of success of different actions (work methods), and not on the amount of performance of these actions. In combining these two methods, this paper proposes a model and gives the optimal incentive contracts. By providing the suitable incentive contract to the agent, the principal can motivate the agent to be more innovative but to be more exerting effort to obtain more output. In the context of managerial compensation, an optimal innovation-motivating incentive scheme can be implemented via a combination of stock options with long vesting periods, option re-pricing, golden parachutes and managerial entrenchment.