DP12199-3 | Government Financing of R&D: A Mechanism Design Approach

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We study how to design an optimal government loan program for risky R&D projects with positive externalities. With adverse selection, the optimal government contract involves a high interest rate but nearly zero co-financing by the entrepreneur. This contrasts sharply with observed loan schemes. With adverse selection and moral hazard (two effort levels), the optimal policy consists of a menu of at most two contracts, one with high interest and zero self-financing, and a second with a lower interest plus co-financing. We simulate the model to assess welfare gains from the optimal policy relative to observed loan programs and a direct subsidy to the private venture capital market. The gains vary with the size of the externalities, cost of public funds, and effectiveness of the private VC industry and, for some parameters, the VC subsidy is superior to the optimal loan policy.