Motivating Innovation with Misspecified Contracts

Abstract: We propose a new principal-agent framework where a principal communicates a roadmap -- a set of plausible outcome models and a prior belief over them -- to guide an agent who is learning the value of innovation. The agent trusts the prior but fears that each model is misspecified (or incorrect). In dynamic contracting, we find an impossibility result: the agent may fall into a breakthrough trap, where early unexplained success can raise his misspecification concerns to the point that no contract can motivate him to continue innovating. We also obtain an upper bound on the frequency of innovative activity that tightens as the degree of misspecification increases, which then causes innovation cycles to emerge endogenously in the long run. In static contracting, we show that diversifying the roadmap increases the principal's profit by reducing the agent's exposure to idiosyncratic epistemic risk.