Agency frictions, managerial compensation, and disruptive innovations

Abstract

Whether a manager leads the innovation efforts of a firm in line with shareholder preferences is key for firm value and growth. This, in turn, influences aggregate productivity growth and welfare. Data on US public firms reveals that (i) firms with better corporate governance tend to adopt highly incentivized contracts rich in stock options and (ii) such contracts are more likely to lead to disruptive innovations – patented inventions that are in the upper tail of the distribution in terms of quality and originality. Motivated by these empirical results, we develop and estimate a new dynamic general equilibrium model of firm-level innovation with agency frictions and endogenous determination of executive contracts. The model is used to study the joint dynamics of corporate governance, managerial compensation, and disruptive innovations, as well as the consequent aggregate implications on growth and welfare. Better corporate governance can reduce the influence of the manager in determining the compensation structure. This leads to more incentivized contracts and boosts innovation, with substantial benefits for the shareholders as well as the broader economy through knowledge spillovers. Removing agency frictions leads to contracts richer in stock options, boosting growth by 0.51pp, and welfare by 7.3% in consumption-equivalent terms. These findings are robust to incorporating short-termism. Short-termism itself is also detrimental, the removal of which increases welfare by 1.5%. Alleviating both frictions at the same time leads to amplified gains in growth and welfare.