Is Pay for Performance Detrimental to Innovation?

Previous research in economics shows that compensation based on the pay‐for‐performance principle is effective in inducing higher levels of effort and productivity. On the other hand, research in psychology argues that performance‐based financial incentives inhibit creativity and innovation. How should managerial compensation be structured if the goal is to induce managers to pursue more innovative business strategies? In a controlled laboratory setting, we provide evidence that the combination of tolerance for early failure and reward for long‐term success is effective in motivating innovation. Subjects under such an incentive scheme explore more and are more likely to discover a novel business strategy than subjects under fixed‐wage and standard pay‐for‐performance incentive schemes. We also find evidence that the threat of termination can undermine incentives for innovation, whereas golden parachutes can alleviate these innovation‐reducing effects.