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Economics of Industry Paper
Government financing of R&D: A mechanism design approach
Saul Lach, Zvika Neeman and Mark Schankerman
June 2020
Paper No' EI 55:
Full Paper (pdf)

JEL Classification: D61; D82; O32; O38

Tags: mechanism design; innovation; r&d; entrepreneurship; additionality; government finance; venture capital

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 private venture capital firms. The gains vary with the size of the externalities, cost of public funds, and effectiveness of the private VC industry.