Effects of Performance-Based Contracts on Innovation in Inter-Organizational Relationships

Abstract

Recent contributions suggest that a specific type of contract that has intentionally been left incomplete, the performance-based contract (PBC), fosters innovation in inter-organizational relationships. Studies on PBCs are mostly context-specific and have hardly empirically demonstrated their effects on performance outcomes. We study the effects of PBCs on innovation by means of a survey study. More specifically, we investigate how the two main features of PBCs, i.e., low term specificity and rewards being tied to performance (i.e., pay-for-performance), affect incremental and radical innovation using data on 106 inter-organizational relationships from the Dutch maintenance industry. We find that term specificity is inverse-U related to incremental innovation, but not related to radical innovation. Pay-for-performance positively affects both, incremental and radical innovation. Finally, the partner's degree of risk-aversion negatively affects incremental and radical innovation.