Abstract
This paper investigates the impact of state subsidy on the behavior of the entrepreneur under asymmetric information. Several authors formulated concerns about state intervention as it can aggravate moral hazard in corporate financing. In the seminal paper of Holmström and Tirole (Q J Econ 112(3):663–691, 1997) a two-player moral hazard model is presented with an entrepreneur initiating a risky scalable project and a private investor (e.g. bank or venture capitalist) providing outside financing. The novelty of our research is that this basic moral hazard model is extended to the case of positive externalities and to three players by introducing the state subsidizing the project. It is shown that in the optimum, state subsidy does not harm, but improves the incentives of the entrepreneur to make efforts for the success of the project; hence in effect state intervention reduces moral hazard. Consequently, state subsidy increases social welfare which is defined as the sum of private and public net benefits. Also, the exact form of the state subsidy (ex-ante/ex-post, conditional/unconditional, refundable/nonrefundable) is irrelevant in respect of the optimal size and the total welfare effect of the project. Moreover, in case of nonrefundable subsidies state does not crowd out private investors; but on the contrary, by providing additional capital it boosts private financing. These results are mainly due to the special mechanism imbedded in our model by which the private investor is able to transform even the badly designed state subsidies into a success fee which is optimal from the incentive point of view.
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Notes
Investors are supposed to hold a large diversified portfolio and this project is just one element of it. Hence, with regard to this special project they can be supposed to have unlimited liability.
Csóka et al. (2015) also developed the same basic model by introducing a new player: the buyer of the entrepreneur.
Berlinger et al. (2015a) present a model where the players (state, entrepreneur and private investor) make a three-sided contract in one round.
If it is given out at the end irrespectively whether the project succeeds or fails, it can be considered as the combination of the two (forms 2 and 3).
A comprehensive summary of state subsidies can be found in Walter (2014).
Apart from these two cases, the return to the private investor in failure (\(r_{i})\) equals zero similarly to the basic two-player case.
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Acknowledgements
This paper was supported by the János Bolyai Research Scholarship of the Hungarian Academy of Sciences, by the Momentum Programme (LP-004/2010), by the research grant of the Corvinus Business School, and by Pallas Athene Domus Scientiae Foundation. The views expressed are those of the authors and do not necessarily reflect the official opinion of the supporters.
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Appendices
Appendix 1: Empirical literature
See Table 7.
Appendix 2: Characteristics of the optimum
See Tables 8, 9, 10, 11, 12, 13, and 14.
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Berlinger, E., Lovas, A. & Juhász, P. State subsidy and moral hazard in corporate financing. Cent Eur J Oper Res 25, 743–770 (2017). https://doi.org/10.1007/s10100-016-0461-8
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DOI: https://doi.org/10.1007/s10100-016-0461-8