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Innovation-driven Economy and Optimal Low-powered Incentive Mechanism Design (No.C2013002)

Date:2013-08-27

Tian Guoqiang, Meng Daweng
(Shanghai University of Finance and Economics and Texas A&MUniversity; Shanghai University of Finance and Economics)

August, 2013

Abstract: This paper discusses the issue of designing the optimal incentive mechanisms in the process of transition from factor-driven to innovation-driven economy. In the factor-driven stage of Chinese economy, labor forces are relatively abundant, and the principal's goals are relatively sensitive to the agent's efforts. The incentive effect dominates the insurance effect, and the high-powered incentive contract which ties the agents' pay with their performance is therefore necessary and reasonable. In contrast, this paper shows that in the innovation-driven stage, the case is opposite, the low-powered incentive contract is therefore better than the high-powered one. Moreover, we show that the joint presence of moral hazard and adverse selection calls for a further downward distortion of the power of incentives. This provides a brand new explanation to the commonly observed phenomena of low-powered incentives and thus proves the necessity of low-powered incentives to the innovation-driven economy.
Keywords: Low-powered Incentive; Optimal Mechanism Design; Moral Hazard; Adverse Selection; Hybrid Model

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