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Journal of Economics

, Volume 118, Issue 1, pp 77–89 | Cite as

Moral hazard in innovation: the relationship between risk aversion and performance pay

  • Pu Chen
  • Sanxi Li
  • Jianye Yan
  • Xundong Yin
Article

Abstract

Standard principal–agent models study the situation in which there is moral hazard within a given production method. The classic prediction of these models is that incentives tend to decrease with risk and risk averseness of the agent. The prediction is inconsistent with empirical findings, which reveal that both negative and positive relationships between risk and the power of incentives co-exist in the real-world. Our paper develops a tractable model to illustrate that introducing innovation effort could well explain the puzzle of the relationships between the power of incentives, risk and risk-averseness of the agent. In particular, we assume that the agent can exert two unobservable efforts: a production effort and an innovation effort. While the production effort can increase output within a particular production method, the innovation effort can generate an innovative but riskier production method. We show that, when inducing innovation is unnecessary, the standard result that incentives tend to decrease with risk and risk averseness holds. However, when inducing innovation becomes necessary, incentives may increase with risk and risk averseness. The insights in this paper are especially important today, when innovative but riskier technologies upgrade very quickly.

Keywords

Risk aversion The power of incentive The production effort The innovation effort 

JEL Classification

D80 J33 

Notes

Acknowledgments

The authors thank David Martimort, Wilfried Sand-Zantman and three anonymous referees for their valuable comments and constructive suggestions. For financial support: Sanxi Li acknowledges the National Natural Science Foundation of China (71303245) and the Ministry of Education of China (13YJC790077); Jianye Yan is grateful to the National Natural Science Foundation of China (71401034), the Ministry of Education of China (13YJC790174), the Fundamental Research Funds for the Central Universities in UIBE (14YQ06), and the Project-sponsored by SRF for ROCS, SEM and Xundong Yin thanks the program for innovation research in Central University of Finance and Economics.

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Copyright information

© Springer-Verlag Wien 2015

Authors and Affiliations

  1. 1.School of EconomicsRenmin University of ChinaBeijingChina
  2. 2.Research Center for Games and Economic BehaviorShandong UniversityJinanChina
  3. 3.School of Banking and FinanceUniversity of International Business and EconomicsBeijingChina
  4. 4.CAPFPPCentral University of Finance and EconomicsBeijingChina

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