The Organization of Production: Moral Hazard and R&D

We model technical innovation of a final good at the subcomponent level. Research and Development efforts are undertaken on subcomponents, incrementally enhancing the technological inputs to the final good. Through observation of actual R and D procurements, we identify the principal and agents appropriate for such innovation. Two categories of agent, the conventional profit seeking agent and a performance seeking agent, are identified. A principal who jointly values the capabilities of the subcomponent undergoing R and D and the funds available for purchasing other subcomponents to the final good is identified. The principal does not have a transferable utility function. We characterize optimal R and D production organization between such a principal and each type of agent. In addition to the importance of the information environment between principal and agent, the motivational properties of the principal and agent significantly affect the form and existence of optimal R and D procurement. We draw insights for both private and public sector industrial organization.