Using public funds to incentivize innovation in young, innovative firms: Insights on the optimal use and design of public support instruments drawn from theoretical models

Abstract

This thesis analyses, from a theoretical perspective, how public funds should optimally be used to finance private innovation in young, innovative firms. It is conducted as a literature review. The need for public intervention is first justified in detail: Firms make investment decisions based on expected private returns, which means that they do not take into consideration the positive externalities that innovations generate. This leads to firms innovating less than what would be optimal from the whole society’s point of view. Certain financial market imperfections further exacerbate the issue.

In the core of the thesis, I discuss three theoretical models that analyse the optimal use and design of certain policy instruments. The core relies, for the most part, on work by Bayar et al. (2016), Berlinger (2019) and Lach et al. (2021).

The findings suggest that subsidy and prize programmes can, in many scenarios, increase the level of private innovation. Their relative performance depends on the size of the costs associated with subsidy programmes. Such costs stem from the fact that subsidies are paid out ex ante which leads to, for instance, supporting some firms that do not end up investing innovation. Meanwhile, prizes are paid out ex post, after an innovation has been developed. The optimal size of subsidies and prizes can depend on multiple variables, such as the fraction of an innovation’s value that its innovator is able to appropriate and the social cost of public funds.

Government loan programmes can likewise help induce more private innovation. Depending on the situation, an optimal loan can be one which is characterized by a relatively high interest rate but which does not place requirements on how much of its own financing the firm uses, or one with a clearly lower interest rate but a high self-financing requirement. Some forms of channelling public funds through private venture capital funds can also induce more innovation. Guarantees that help firms recover financially in case of project failure might, on the other hand, even reduce the level of innovation.