Monitoring innovation

Abstract

This paper examines the benefit of monitoring an agent who works on an innovative project of uncertain quality. The agent is asked to experiment to uncover the quality of the project. The agent has the ability to manipulate the principal's beliefs about the project quality because the effort of the agent may not be observable (moral hazard), and success may not be publicly observed (hidden information). The optimal timing of monitoring trades off the benefit of alleviating the moral hazard problem during the monitoring period (static effect) and a reduction of the agent's rent in periods before monitoring (dynamic effect). If the successful realization of the innovation is observed publicly, the static effect dominates, and monitoring is most beneficial at the beginning of the relationship. If success is private, the dynamic effect may become pivotal, and monitoring may be optimal at the end of the relationship.