Is Pay for Performance Detrimental to Innovation?

Previous research has argued that compensation plans based on the pay-forperformance principle are effective in inducing higher levels of effort and in avoiding diversion of funds by managers. How should managerial compensation be structured if the problem is to induce managers to pursue more innovative business strategies? In a controlled laboratory experiment, we provide evidence that the combination of tolerance for early failure and reward for long-term success is successful in motivating innovation. Subjects under such an incentive scheme explore more and are more likely to discover a novel business strategy than subjects under fixed-wage and standard pay-for-performance incentive schemes. We also find evidence that the threat of termination can undermine incentives for innovation, while golden parachutes can alleviate these innovation-reducing effects. We would like to thank Dan Ariely, Nittai Bergman, Bruno Biais, Arthur Campbell, Ernst Fehr, Bob Gibbons, Lorenz Götte, Bengt Holmstrom, Robert Marquez, Muriel Niederle, Enrico Perotti, Thomas Philippon, Sebastien Pouget, Drazen Prelec, Panle Jia, David Robinson, Andrei Shleifer, Johannes Spinnewijn, Antoinette Schoar, Jean Tirole, Eric Van den Steen, Christian Zehnder and seminar participants at Berkeley Haas, Chicago GSB, Gerzensee, LSE, Toulouse, University of Munich, the Harvard-MIT Organizational Economics Seminar, the Kauffman Summer Legal Institute, the RFS-EFIC and the NBER Corporate Finance Meeting for helpful comments as well as Hareem Ahmad and Yasmin SanieHay for outstanding research assistance. Financial support from the NBER Innovation, Policy, and the Economy group and the Ewing Marion Kaufmann Foundation is gratefully acknowledged. Anderson School of Management, University of California, Los Angeles, 110 Westwood Plaza Suite D515, Los Angeles, CA 90095, [email protected], (310) 825-7348. MIT Sloan School of Management, 50 Memorial Drive E52-446, Cambridge, MA 02142-1347, [email protected], (617) 253-7218.