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Motivating Innovation with Misspecified Contracts

Florian Mudekereza

Abstract

We propose a new principal-agent framework where a principal communicates a roadmap -- a set of plausible outcome models and a prior belief over them -- to guide an agent who is learning the value of innovation. The agent trusts the prior but fears that each model is misspecified (or incorrect). In dynamic contracting, we find an impossibility result: the agent may fall into a breakthrough trap, where early unexplained success can raise his misspecification concerns to the point that no contract can motivate him to continue innovating. We also obtain an upper bound on the frequency of innovative activity that tightens as the degree of misspecification increases, which then causes innovation cycles to emerge endogenously in the long run. In static contracting, we show that diversifying the roadmap increases the principal's profit by reducing the agent's exposure to idiosyncratic epistemic risk.

Motivating Innovation with Misspecified Contracts

Abstract

We propose a new principal-agent framework where a principal communicates a roadmap -- a set of plausible outcome models and a prior belief over them -- to guide an agent who is learning the value of innovation. The agent trusts the prior but fears that each model is misspecified (or incorrect). In dynamic contracting, we find an impossibility result: the agent may fall into a breakthrough trap, where early unexplained success can raise his misspecification concerns to the point that no contract can motivate him to continue innovating. We also obtain an upper bound on the frequency of innovative activity that tightens as the degree of misspecification increases, which then causes innovation cycles to emerge endogenously in the long run. In static contracting, we show that diversifying the roadmap increases the principal's profit by reducing the agent's exposure to idiosyncratic epistemic risk.
Paper Structure (68 sections, 33 theorems, 266 equations)

This paper contains 68 sections, 33 theorems, 266 equations.

Table of Contents

  1. Introduction
  2. Framework
  3. Principal, agent, and wages
  4. Principal's problem
  5. Discussion: roadmap and misspecification
  6. Static Contracts
  7. Existence
  8. Wage structure
  9. Example.
  10. Comparative statics
  11. Misspecification concerns
  12. Second-order dispersion
  13. Dynamic Contracts
  14. Two-period contracting environment
  15. Endogenous misspecification concerns
  16. ...and 53 more sections

Key Result

Proposition 1

Fix some action $a^*\in A$.

Theorems & Definitions (73)

  • Definition 1: Feasible set
  • Proposition 1: Optimal contract
  • Proposition 2
  • Proposition 3
  • Lemma 1
  • Definition 2
  • Theorem 1: Breakthrough trap
  • Corollary 1
  • Corollary 2
  • Corollary 3
  • ...and 63 more