Business Start-ups and Productive Efficiency

This paper studies efficient allocation of resources in an economy in which potential entrepreneurs are heterogeneous initially regarding their wealth levels and whether they have ideas or not. An agent with an idea can start a business which generates random returns. I assume agents have private information about (1) their initial types, (2) the level of investment in their businesses, and (3) the realized returns. Returns being unobservable creates a novel motive for redistribution towards agents who are productive but lack resources to invest in their ideas. To analyze this motive in isolation I assume agents are risk-neutral and abstract away from equality and insurance considerations. The unobservability of wealth and productivity implies that the redistribution that poor agents with ideas get is limited by incentive-compatibility: the society should provide other agents with enough incentives so that they do not claim to be poor and productive. Efficient amount of redistribution from unproductive agents to productive ones arises from this trade-off. The paper then provides an implementation of this efficient allocation in an incomplete markets setup with very simple taxes on bond holdings: those who lend in the market are taxed and the proceeds are used to subsidize borrowers. Finally, I extend the model to allow for unobservable risk-free technology and negative consumption, and show that the redistribution result and its implementation are robust to these generalizations of the model.