Edited by Robert E. Litan
Chapter 5: Incentives for Innovation: Bankruptcy, Corporate Governance, and Compensation Systems
* Florian Ederer and Gustavo Manso** 5.1 INTRODUCTION Across all of the social sciences, researchers often model the innovation process as the cumulative, interactive recombination of existing bits of knowledge in novel ways to improve over existing ways of doing things (Schumpeter (1934), Weitzman (1998)). But how do these novel recombinations that generate innovation come about? One view is that from time to time inventors, either by luck or talent, stumble upon new combinations that are superior to conventional ways of doing things. Of course, if luck and talent are all that is needed for innovation, then much of the innovation process is essentially uncontrollable and there is little that economists could contribute to the debate. However, an extensive literature in economics and finance argues that the intensity and direction of people’s innovative activities are influenced by incentives in the form of laws, institutions, customs, regulations, and compensation systems. In this chapter, we describe and discuss some of the theoretical and empirical contributions to this literature. Our focus is primarily on papers that study the problem from an optimal contracting perspective, and on applications to bankruptcy, corporate governance, and compensation systems. The chapter is organized as follows. Section 5.2 discusses the literature on incentive problems in economics with a particular emphasis on incentives for innovation, and relates the main results to some of the findings of the psychology literature on this topic. Section 5.3 discusses applications of these ideas to bankruptcy laws, corporate governance, and compensa- * The focus of this chapter...
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