Motivating innovation is an important concern in many incentive problems. For example, shareholders of large corporations often need to motivate managers to pursue more innovative business strategies. This paper shows that the optimal incentive scheme that motivates innovation exhibits substantial tolerance (or even reward) for early failure and reward for long-term success. Moreover, commitment to a long-term compensation plan, job security, and timely feedback on performance are also essential ingredients to motivate innovation. In the context of managerial compensation, the optimal incentive scheme that motivates innovation can be implemented via a combination of stock options with long vesting periods, option repricing, golden parachutes, and managerial entrenchment.

Traditional theories argue that governance is strongest under a single large blockholder, as she has large incentives to undertake value-enhancing interventions. However, most firms are held by multiple small blockholders. This paper shows that, while such a structure generates free-rider problems that hinder intervention, the same co-ordination difficulties strengthen a second governance mechanism: disciplining the manager through trading. Since multiple blockholders cannot co-ordinate to limit their orders and maximize combined trading profits, they trade competitively, impounding more information into prices. This strengthens the threat of disciplinary trading, inducing higher managerial effort. The optimal blockholder structure depends on the relative effectiveness of manager and blockholder effort, the complementarities in their outputs, information asymmetry, liquidity, monitoring costs, and the manager's contract. (JEL D82, G14, G32) * We thank an anonymous referee, the Editor

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This paper tests the hypothesis that freedom to experiment, tolerance for early failure, long time horizons to evaluate results, and detailed feedback on performance stimulate creativity and innovation in scientific research. We do so by studying the careers and output of U.S. academic life scientists funded through two very distinct mechanisms: investigator-initiated R01 grants from the NIH, or appointment as an investigator of the Howard Hughes Medical Institute (HHMI), whose funding practices embody many of the elements mentioned above. Using careful adjustment for selection on observables, we find that HHMI investigators produce high-impact papers at a much higher rate than two control groups of similarly-accomplished NIH-funded scientists. In contrast, the program does not appear to have much effect on the raw number of articles published. We also observe large effects on the probability of being elected to prestigious scientific societies or the training of students that go on to win early career prizes.

Previous research in economics shows that paying the agent based on performance induces the agent to exert more effort thereby enhancing productivity. On the other hand, research in psychology argues that performance-based financial incentives may inhibit creativity and innovation. In a controlled laboratory experiment, we provide evidence that the combination of tolerance for early failure and reward for long-term success is effective 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. Our results suggest that appropriately designed incentives are useful in motivating creativity and innovation.