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Central European Journal of Operations Research

, Volume 25, Issue 4, pp 743–770 | Cite as

State subsidy and moral hazard in corporate financing

  • Edina Berlinger
  • Anita Lovas
  • Péter Juhász
Original Paper

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.

Keywords

Contract theory Externalities Asymmetric information Crowding out 

JEL Classification

D28 D86 G38 H23 H81 

Notes

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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Copyright information

© Springer-Verlag Berlin Heidelberg 2016

Authors and Affiliations

  1. 1.Department of FinanceCorvinus University of BudapestBudapestHungary

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