DP12199 | Government Financing of R&D: A Mechanism Design Approach

Publication Date

08/04/2017

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Abstract

We study the design of a government loan program for risky R&D projects that generate positive externalities, undertaken by entrepreneurs in a competitive capital market environment. With adverse selection, the optimal contract requires a high interest rate but nearly zero co-financing by the entrepreneur. This contrasts sharply with observed policies, typified by a low interest rate and high co-finanacing requirement. When we add moral hazard (endogenous success), the optimal policy consists of a menu of at most two contracts, one with high interest/zero self-finanacing and a second with a lower interest but also a co-finanacing requirement. Calibrated simulations compare the optimal policy and observed program designs in terms of innovation and welfare.