Incentive Contracts Under Product Market Competition and R&D Spillovers

This paper studies cost-reducing R&D incentives in a principal-agent model with product market competition. It argues that moral hazard does not necessarily decrease firms' profits in this setting. In highly competitive industries, firms are driven by business-stealing incentives and exert such high levels of R&D that they burn up their profits. In the presence of moral hazard, underprovision of R&D incentives due to risk sharing can generate considerable cost savings, implying higher profits for both rivals. This result indicates firms' incentives to adopt collusive-like behavior in the R&D market. We also examine the agents' contracts and the profits-risk relationship when cross-firm R&D spillovers occur.