This paper, authored by Bengt Holmström and presented at the IUI Conference on Markets for Innovation, Ownership and Control in 1988, explores the relationship between agency costs and innovation. The author argues that small firms are disproportionately responsible for significant innovations due to the optimal assignment of tasks across individuals and organizations. The paper highlights that incentive costs associated with a given task depend on the total portfolio of tasks undertaken, making it costly to mix hard-to-measure activities (innovation) with easy-to-measure activities (routine). Larger firms are at a disadvantage in conducting highly innovative research due to the costs of managing a heterogeneous set of tasks. The paper also discusses how optimal organizational responses to coordination and control of routine tasks can lead to bureaucratization within firms and financial constraints imposed by capital markets, both of which are hostile to innovation. The author uses a simple principal-agent model to illustrate the trade-offs involved in managing innovation, emphasizing the importance of balancing incentives and risk sharing. The paper concludes by discussing the implications for corporate bureaucratization and the role of capital markets in innovation.This paper, authored by Bengt Holmström and presented at the IUI Conference on Markets for Innovation, Ownership and Control in 1988, explores the relationship between agency costs and innovation. The author argues that small firms are disproportionately responsible for significant innovations due to the optimal assignment of tasks across individuals and organizations. The paper highlights that incentive costs associated with a given task depend on the total portfolio of tasks undertaken, making it costly to mix hard-to-measure activities (innovation) with easy-to-measure activities (routine). Larger firms are at a disadvantage in conducting highly innovative research due to the costs of managing a heterogeneous set of tasks. The paper also discusses how optimal organizational responses to coordination and control of routine tasks can lead to bureaucratization within firms and financial constraints imposed by capital markets, both of which are hostile to innovation. The author uses a simple principal-agent model to illustrate the trade-offs involved in managing innovation, emphasizing the importance of balancing incentives and risk sharing. The paper concludes by discussing the implications for corporate bureaucratization and the role of capital markets in innovation.