Book excerpt: This paper examines the strategic use of managerial compensation in an environment where a firm invests in projects which, if successful, can provide a competitive advantage over rival firms in the final product market. In particular, I study the interaction between managerial compensation policy and the investment strategies of competing firms in a model where the future stochastic payoffs from investment can depend on the firms' own actions as well as the actions taken by rivals. Examples of investments of this type include the development of new products/processes (e.g., expenditures on research and development (Ramp;D)), the expansion of production capacity, and advertising and marketing campaigns aimed at increasing the firm's market share at the expense of rivals. It is shown that the strategic interaction between firms will generally result in overinvestment in innovation relative to a benchmark case in which compensation policy is not used in a strategic fashion.