How to incentivise internal innovation in the face of competition?

This paper studies how between-firm competition affects firms’ ability to provide employees with incentives to innovate. In a relatively simple moral hazard framework, it derives the optimal dynamic contract to induce employees to pursue innovative work methods rather than using known work methods. Subsequently, it analyses the firms’ choice of action to engage in, as well as the associated efficiency of the chosen method. Results show how, if a worker is to explore new production methods, he may need to be rewarded for early failure, which can be impossible for a firm operating under competition. This is caused by the lower expected profits, as well as by the increased competition for shareholders imposing constraints on the liquidity of a firm. Stakeholders would be more difficult to attract to any one firm, the more firms there are in the industry, implying that firms should avoid making losses in early stages. Thus, under certain conditions, less competition may prove to be beneficial for the overall efficiency of the market, while in other cases more competition could be more efficient.1