Managerial compensation and research and development investment in a two-period agency setting

Abstract

To investigate the relationship between managerial compensation and research and development (R&D) investment under asymmetric information, this paper establishes a two-period principal-agency model, in which the firm owner hires a risk-averse manager to operate the firm and to make the R&D investment decision. The manager has private information regarding the profitability of the R&D investment. Firstly, we present an R&D investment problem under symmetric information as the benchmark. Then, we discuss the scenario with asymmetric information about the profitability, and the firm owner offers new optimal incentive contact. We compare the differences of the company’s R&D investment decisions and choices of the compensation contract under symmetric and asymmetric information cases by numerical experiments. We find that the manager receives an upward distortion in the first-period bonus share rate, and a downward distortion in the second-period bonus share rate. Meanwhile, the R&D investment is less than the symmetric information case. At last, the variable outside option has no effect on the optimal manager’s compensation contract when the marginal cost of R&D investment is relatively small or under symmetric information case.