A Dynamic Model of Targeting in R and D Contracts

Abstract

This paper extends our earlier work on dynamic models of R and D contracts to a case in which the firm must specify, in each period of the contractual horizon, a research “target,” which will govern payoffs in the next period. Targets may be “safe” or “risky.” By definition, the former are less than the firm’s existing stock of knowledge while the latter exceed it. We show that the firm is more likely to do research the longer the contractual horizon (given a suitably high discount rate), the lower the research costs, and the higher the level of sponsor knowledge. Such parameter changes also imply it is more likely to set a risky target. We also establish a number of results relating to changes in parameters to the optimal level of safe and risky targets. Finally, we analyze the intertemporal relationship between the targeting decision and incentives to do research.