How to Motivate Fundamental Innovation: Subsidies versus Prizes and the Role of Venture Capital

In this paper, we analyze the mechanisms through which governments and non-profit agencies (principals) may incentivize the development of fundamental innovations, defined as those innovations that have positive social value net of development costs, but have negative net present values to the innovating firms due to the limited appropriability of their value by such firms. We solve for the principal’s optimal choice between subsidy schemes and incentivizing prizes under two alternative assumptions: first, where the producing firms’ innovation development costs are observable by the principal; and second, where such costs are unobservable. We then introduce venture capitalists (VCs) into the above setting and analyze how VCs may enhance the efficiency of the principal in motivating fundamental innovations. Our analysis has several implications for how to better incentivize innovation development, and in particular, for how government-funded venture capitalists may enhance innovation.