The knowledge-incentive trade-off: Understanding the relationship between organizational design and innovation

Abstract

Managers face a fundamental trade-off when designing their organizations for innovation. On the one hand, a differentiated design with more independent sub-units is associated with high observability of effort and the ability to use higher powered incentives, increasing efforts to innovate. On the other hand, greater differentiation reduces intra-organizational knowledge flows which can hinder innovation. I offer a framework to understand the implications of this trade-off for firms’ innovation outcomes. To do so, I unpack the innovation process into upstream tasks around invention, and downstream tasks around product development and commercialization. I argue that knowledge flows play a more important role towards upstream tasks and incentives play a more important role towards downstream tasks. I explore this premise using fine- grained data on firms’ organizational designs and their innovation outcomes in terms of upstream inventions and downstream product development in the global pharmaceutical industry from 1995 to 2015. I find that greater differentiation while yielding higher numbers of inventions (e.g., patents) is associated with less original inventions that draw on a narrower array of knowledge, and fewer inventions progressing through the earlier stages of development. In contrast, greater differentiation is associated with more inventions progressing through the later stages of development. These findings highlight how the knowledge- and incentives-based perspectives are intertwined with respect to firms’ organizational design, and that viewing innovation as a process can help uncover the trade-offs associated with firms’ design choices.