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

Author(s): Saul Lach, Zvika Neeman, Mark Schankerman
Publication Date: August 2017
Date Revised: March 2020
Keyword(s): additionality, entrepreneurship, government finance, Innovation, mechanism design, R&D, start-ups
JEL(s): D61, D82, O32, O38
Programme Areas: Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=12199

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. Calibrated simulations assess welfare gains from the optimal policy, 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.