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State subsidy and moral hazard in corporate financing

Author

Listed:
  • Edina Berlinger

    () (Corvinus University of Budapest)

  • Anita Lovas

    () (Corvinus University of Budapest)

  • Péter Juhász

    () (Corvinus University of Budapest)

Abstract

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.

Suggested Citation

  • Edina Berlinger & Anita Lovas & Péter Juhász, 2017. "State subsidy and moral hazard in corporate financing," Central European Journal of Operations Research, Springer;Slovak Society for Operations Research;Hungarian Operational Research Society;Czech Society for Operations Research;Österr. Gesellschaft für Operations Research (ÖGOR);Slovenian Society Informatika - Section for Operational Research;Croatian Operational Research Society, vol. 25(4), pages 743-770, December.
  • Handle: RePEc:spr:cejnor:v:25:y:2017:i:4:d:10.1007_s10100-016-0461-8
    DOI: 10.1007/s10100-016-0461-8
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    1. repec:spr:cejnor:v:25:y:2017:i:4:d:10.1007_s10100-016-0461-8 is not listed on IDEAS
    2. Edina Berlinger & Anita Lovas & Péter Juhász, 2017. "State subsidy and moral hazard in corporate financing," Central European Journal of Operations Research, Springer;Slovak Society for Operations Research;Hungarian Operational Research Society;Czech Society for Operations Research;Österr. Gesellschaft für Operations Research (ÖGOR);Slovenian Society Informatika - Section for Operational Research;Croatian Operational Research Society, vol. 25(4), pages 743-770, December.
    3. repec:pkk:meb017:453-460 is not listed on IDEAS
    4. repec:spr:cejnor:v:25:y:2017:i:4:d:10.1007_s10100-017-0482-y is not listed on IDEAS

    More about this item

    Keywords

    Contract theory; Externalities; Asymmetric information; Crowding out;

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
    • H23 - Public Economics - - Taxation, Subsidies, and Revenue - - - Externalities; Redistributive Effects; Environmental Taxes and Subsidies
    • H81 - Public Economics - - Miscellaneous Issues - - - Governmental Loans; Loan Guarantees; Credits; Grants; Bailouts

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