Adverse selection and financing of innovation: is there a need for R&D subsidies?

TLDR: In this paper, the interaction of private and public funding of innovative projects in the presence of adverse-selection based financing constraints is studied, and it is shown that under certain conditions, public R&D subsidies can reduce the financing constraints of technology-based entrepreneurial firms.

Abstract: We study the interaction of private and public funding of innovative projects in the presence of adverse-selection based financing constraints. Government programs allocating direct subsidies are based on ex ante screening of the subsidy applications. This selection scheme may yield valuable information to market-based financiers. We find that under certain conditions, public R&D subsidies can reduce the financing constraints of technology-based entrepreneurial firms. First, the subsidy itself reduces the capital costs related to the innovation projects by reducing the amount of market-based capital required. Second, the observation that an entrepreneur has received a subsidy for an innovation project provides an informative signal to the market-based financiers. We also find that public screening works more efficiently if it is accompanied with subsidy allocation.

Figures

Figure 5. Change in region 1, when a subsidy program is introduced

Figure 1. Market-based financing with different values of initial capital

Figure 6. Change in funding gap region as a subsidy program is introduced

Figure 4. Optimal strategies for government with different values of μ

Figure 3. Plausible government strategies with different values of screening costs (σ) and different share of high-type entrepreneurs in the economy (p)

Figure 2. Extensive-form representation of the application process with perfect screening

Full text

Tuomas Takalo – Tanja Tanayama
Adverse selection and fi nancing of
innovation: is there a need for R&D
subsidies?
Bank of Finland Research
Discussion Papers
19 • 2008

Suomen Pankki
Bank of Finland
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Bank of Finland Research
Discussion Papers
19
•
2008
Tuomas Takalo* – Tanja Tanayama**
Adverse selection and financing
of innovation: is there a need for
R&D subsidies?
The views expressed in this paper are those of the authors and
do not necessarily reflect the views of the Bank of Finland.
* E-mail: tuomas.takalo@bof.fi. Corresponding author.
** E-mail: tanja.tanayama@helsinki.fi.
We would like to thank four anonymous referees for their
extensive comments. We would also thank Ari Hyytinen, Saul
Lach, Pere Ortín Ángel, Petri Rouvinen, Otto Toivanen, John
Van Reenen, Timo Vesala, Juuso Välimäki and seminar
audiences at the University of Jyväskylä, conference on the
Dynamics of SBEFs in Sestri Levante, the 34th EARIE
conference in Seville, Bank of Finland and Helsinki School of
Economics for their comments. We also gratefully
acknowledge financial support from the Finnish Funding
Agency for Technology and Innovation (TEKES).

http://www.bof.fi
ISBN 978-952-462-454-1
ISSN 0785-3572
(print)
ISBN 978-952-462-455-8
ISSN 1456-6184
(online)
Helsinki 2008

3
Adverse selection and financing of innovation: is there
a need for R&D subsidies?
Bank of Finland Research
Discussion Papers 19/2008
Tuomas Takalo – Tanja Tanayama
Monetary Policy and Research Department
Abstract
We study the interaction between private and public funding of innovative
projects in the presence of adverse-selection based financing constraints.
Government programmes allocating direct subsidies are based on ex-ante
screening of the subsidy applications. This selection scheme may yield valuable
information to market-based financiers. We find that under certain conditions,
public R&D subsidies can reduce the financing constraints of technology-based
entrepreneurial firms. Firstly, the subsidy itself reduces the capital costs related to
innovation projects by reducing the amount of market-based capital required.
Secondly, the observation that an entrepreneur has received a subsidy for an
innovation project provides an informative signal to market-based financiers. We
also find that public screening works more efficiently if it is accompanied by
subsidy allocation.
Keywords: adverse selection, innovation finance, financial constraints, R&D
subsidies, certification
JEL classification numbers: D82, G28, H20, O30, O38

Frequently asked questions

Q1. What contributions have the authors mentioned in the paper "Adverse selection and financing of innovation: is there a need for r&d subsidies?" ?

The authors study the interaction between private and public funding of innovative projects in the presence of adverse-selection based financing constraints. Firstly, the subsidy itself reduces the capital costs related to innovation projects by reducing the amount of market-based capital required. Secondly, the observation that an entrepreneur has received a subsidy for an innovation project provides an informative signal to market-based financiers. The authors find that under certain conditions, public R & D subsidies can reduce the financing constraints of technology-based entrepreneurial firms. 

Q2. What is the main reason why the subsidy is used?

the subsidy itself reduces the capital costs related to innovation projects by reducing the amount of market-based capital required. 

Q3. What is the main purpose of this paper?

The authors find that under certain conditions, public R&D subsidies can reduce the financing constraints of technology-based entrepreneurial firms.