Fostering incremental and radical innovation through performance-based contracting in inter-organizational relationships

In addition to internal innovation, inter-organizational relationships (IOR) have become an increasingly important source of innovation. Such IORs are usually governed by contracts that provide safeguards to opportunistic behavior and failures, yet the majority of contracts are not conducive to innovation. Nevertheless, anecdotal evidence suggests that innovation in IORs can be fostered by applying performance-based contracts (PBCs); yet, to date, our understanding of the underlying mechanisms is limited. This study combines transaction cost economics and agency theory to develop a theoretical model that explains how and under what conditions PBCs lead to innovation. More specifically, we investigate how the two main features of PBCs—low term specificity and rewards that are tied to performance—affect incremental and radical innovation using data on 106 IORs from the Dutch maintenance industry. We find that term specificity has an inverse-U-shaped effect on incremental innovation and a negative effect on radical innovation. Furthermore, pay-for-performance has a stronger positive effect on radical innovation than on incremental innovation. Finally, contrary to our expectations, we find a positive moderation effect of the partner’s degree of risk-aversion on the relationship between pay-for-performance and both types of innovation. We also found that this moderation effect is stronger for radical than for incremental innovation.