Discussion paper

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

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.


Lach, S, Z Neeman and M Schankerman (2017), ‘DP12199 Government Financing of R&D: A Mechanism Design Approach‘, CEPR Discussion Paper No. 12199. CEPR Press, Paris & London. https://cepr.org/publications/dp12199