This paper examines the relationship between agency costs and innovation, focusing on how organizational structures and capital markets affect the ability of firms to innovate. It argues that small firms are disproportionately responsible for significant innovations, but large firms face higher agency costs due to the complexity of managing diverse tasks. These costs include the difficulty of measuring innovation, the risk of misallocating attention or risk, and the need for bureaucratic structures that are hostile to innovation. The paper also discusses how capital markets impose financial constraints on firms, making them more cautious in taking risks. The paper highlights that innovation is a risky, unpredictable, and long-term process that requires significant human effort and is difficult to measure. It argues that current theories of organization, particularly those based on transaction costs and incentive considerations, support the idea that large firms are at a comparative disadvantage in managing truly innovative research. The paper also discusses the challenges of designing incentive contracts for innovation, noting that innovation projects are particularly demanding due to their risk, unpredictability, and long-term nature. The paper further explores the implications of incomplete contracts and the importance of residual decision rights in determining the allocation of resources and the coordination of decision-making. It argues that while integration can improve coordination, it may also dilute incentives for innovation. The paper also discusses the problems of appropriation and measurement in innovation, noting that firms may struggle to capture the returns from innovation due to the difficulty of measuring marginal product and the potential for collusion. Finally, the paper addresses the issue of bureaucratization in large firms, arguing that increased size leads to increased bureaucracy, which can be detrimental to innovation. It suggests that while monitoring can help mitigate some of these issues, it is not sufficient to overcome the challenges posed by collusion and the complexity of managing diverse tasks. The paper concludes that the optimal organizational structure for innovation is one that balances the need for coordination and control with the need to encourage innovation and reduce agency costs.This paper examines the relationship between agency costs and innovation, focusing on how organizational structures and capital markets affect the ability of firms to innovate. It argues that small firms are disproportionately responsible for significant innovations, but large firms face higher agency costs due to the complexity of managing diverse tasks. These costs include the difficulty of measuring innovation, the risk of misallocating attention or risk, and the need for bureaucratic structures that are hostile to innovation. The paper also discusses how capital markets impose financial constraints on firms, making them more cautious in taking risks. The paper highlights that innovation is a risky, unpredictable, and long-term process that requires significant human effort and is difficult to measure. It argues that current theories of organization, particularly those based on transaction costs and incentive considerations, support the idea that large firms are at a comparative disadvantage in managing truly innovative research. The paper also discusses the challenges of designing incentive contracts for innovation, noting that innovation projects are particularly demanding due to their risk, unpredictability, and long-term nature. The paper further explores the implications of incomplete contracts and the importance of residual decision rights in determining the allocation of resources and the coordination of decision-making. It argues that while integration can improve coordination, it may also dilute incentives for innovation. The paper also discusses the problems of appropriation and measurement in innovation, noting that firms may struggle to capture the returns from innovation due to the difficulty of measuring marginal product and the potential for collusion. Finally, the paper addresses the issue of bureaucratization in large firms, arguing that increased size leads to increased bureaucracy, which can be detrimental to innovation. It suggests that while monitoring can help mitigate some of these issues, it is not sufficient to overcome the challenges posed by collusion and the complexity of managing diverse tasks. The paper concludes that the optimal organizational structure for innovation is one that balances the need for coordination and control with the need to encourage innovation and reduce agency costs.