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Authors:

• Jiang Luo
  Nanyang Technological University

• V. Ravi Anshuman
  Indian Institute of Management

We examine how a firm motivates a privately informed manager to engage in innovative activity to search for and invest in a new investment project. In our model, the firm allocates a capital budget to the manager who then decides whether to invest it in the project. We show that relative to the first-best, the firm allocates too little capital and provides too few incentives for the manager to expend innovative effort; the manager may violate the NPV rule by investing the awarded capital in a project with negative productivity. We provide numerous novel predictions about which firms tend to innovate, and in which firms managers tend to follow the NPV rule. We also show that uncertainty and incentive pay can be positively related.