Performance-based incentives and innovative activity in small firms: evidence from German manufacturing

How are financial incentives and innovative activity linked? We analyze how firms' use of financial incentives is associated with their employees' innovative activity. The presence and transparency of financial incentives matter for the link between incentives and innovative activity, just like the activity profile of those receiving incentives. In a study of managers and workers in small German manufacturers, we find that financial incentives and explorative and exploitative innovative activity do interact. Financial incentives for managers (workers) are positively (negatively) associated with exploitative innovative activity, and negatively with exploratory innovative activity for both groups of employees. Furthermore, a transparent compensation system counteracts the negative association of financial incentives for workers on innovation activity, especially exploration. Our study qualifies the claim that extrinsic motivation crowds out innovative activity and specifies under which conditions the use of financial incentives in a firm is associated with different degrees of organizational exploitative and explorative innovative activity.