Essays on Innovation

This dissertation analyzes problems related to barriers to innovation. In the first chapter, “Delegation and Learning”, I study an agency problem which is common in many contexts involving financing of innovation. Consider the example of an entrepreneur, who has an idea but not the money to implement it, and an investor, who has the money but not the idea. In such a case, how should a financial contract between the investor and the entrepreneur look like? How much money should the investor provide the entrepreneur? How should the surplus be divided between them in case the idea turns out to be profitable? There are certain common elements in situations such as these. First, there is an element of learning. This is because initially it is unknown if the idea is profitable or not and hence the idea has to be tried out in the market and both the investor and entrepreneur learn about the profitability of the idea from observing market outcomes. Second, there is an element of delegation in the above situation. This is because decision rights regarding where and when should the idea be tried out is typically in the hands of the entrepreneur and he knows his idea better than the investor. Finally, the preferences of the investor and the entrepreneur might not be aligned. For instance, the investor may receive private benefits, monetary or reputational, from launching products even when these are not profitable. In such a case, how should a contract that incentivizes the entrepreneur to act in the investor’s interest look like? To study these issues, I develop a model in which a principal contracts with an agent whose ability is uncertain. Ability is learnt from the agent’s performance in projects that the principal finances over time. Success however also depends on the quality of the project at hand, and quality is privately observed by the agent who is biased towards implementation. I characterize the optimal sequence of rewards in a relationship that tolerates an endogenously determined finite number of failures and incentivizes the agent to implement only good projects by specifying rewards for success as a function of past failures. The fact that success becomes less likely over time suggests that rewards for success should increase with past failures. However, this also means that the agent can earn a rent from belief manipulation by deviating and implementing a bad project which is sure to fail. I show that this belief-manipulation rent decreases with past failures and implies that optimal rewards are front-loaded. The optimal contract resembles the arrangements used in venture capital, where entrepreneurs must give up equity share in exchange for further funding following failure. In the second chapter, “Informal Risk Sharing and Index Insurance: Theory with Experimental Evidence”, written with Francis Annan, we study when does informal risk sharing act as barrier or support to the take-up of an innovative index-based weather insurance? We evaluate this substitutability or complementarity interaction by considering the case of an individual who endogenously chooses to join a group and make decisions about index insurance. The presence of an individual in a risk sharing arrangement reduces his risk aversion, termed “Effective Risk Aversion” — a sufficient statistic for index decision making. Our analysis establishes that such reduction in risk aversion can lead to either reduced or increased take up of index insurance. These results provide alternative explanations for two empirical puzzles: unexpectedly low take-up for index insurance and demand being particularly low for the most risk averse. Experimental evidence based on data from a panel of field trials in India, lends support for several testable hypotheses that emerge from our baseline analysis. In the third chapter, “Investment Timing, Moral Hazard and Overconfidence”, I study how overconfidence and financial frictions impact entrepreneurs by shaping their incentives to learn. I consider a real option model in which an entrepreneur learns about the quality of project he has, prior to implementation. Success depends on the quality of the project as well as the unknown ability of the entrepreneur. The possibility of the entrepreneur diverting investor funds to his private uses, creates a moral hazard problem which leads to delayed investment and over-experimentation. An entrepreneur who is overconfident regarding his ability, under-experiments and over invests compared to an entrepreneur who has accurate beliefs regarding his ability. Such overconfidence on behalf of the entrepreneur creates inefficiencies when projects are self financed, but reduces inefficiencies due to moral hazard in case of funding by investors.