Subcomponent Innovation and Moral Hazard: Where Technological Progress Meets the Division of Labor

Abstract

I model the technical innovation of a final good as a process of incremental enhancement due to Research and Development (R&D) efforts undertaken on subcomponents to the final good. R&D contracting is analyzed within various principal I agent structures. I identify a principal who jointly values the performance capabilities of the subcomponent undergoing R&D and the funds available for other subcomponents; thus, he does not have a transferable utility function. I justify and characterize a performance seeking agent in addition to the conventional profit seeking agent. The information environment and the motivational properties of the principal and agent significantly affect the form and existence of optimal R&D contracts. I draw insights for private and public sector industrial organization.

Additional Information

This paper is based on the author's Ph.D. thesis, "The Organization of Production: Moral Hazard and R&D," Caltech, May 1993. The author acknowledges the financial support of the Jet Propulsion Laboratory's Flight Projects Office and Director's Discretionary Fund along with the Program on Organization Design within the Division of Humanities and Social Sciences at Caltech. The responsibility for all errors and inconsistencies is borne solely by the author.

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