State subsidy and moral hazard in corporate financing

Berlinger, Edina and Lovas, Anita and Juhász, Péter (2015) State subsidy and moral hazard in corporate financing. Working Paper. Corvinus University of Budapest Faculty of Economics.

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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 (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. In case of refundable subsidies some crowding effects may occur depending on the subsidy form and the parameters.

Item Type:Monograph (Working Paper)
Series Name:Corvinus Economics Working Papers - CEWP
Series Number / Identification Number:2015/22
Uncontrolled Keywords:contract theory, externalities, asymmetric information, crowding out
JEL classification:D82 - Information, Knowledge, and Uncertainty: Asymmetric and Private Information - Mechanism Design
D86 - Information, Knowledge, and Uncertainty: Economics of Contract: Theory
G38 - Corporate Finance and Governance: Government Policy and Regulation
H23 - Taxation and Subsidies: Externalities; Redistributive Effects; Environmental Taxes and Subsidies
H81 - Governmental Loans; Loan Guarantees; Credits; Grants; Bailouts
Divisions:Faculty of Business Administration > Institute of Finance and Accounting > Department of Finance
Funders:Hungarian Academy of Sciences, Momentum Programme (LP-004/2010), Corvinus Business School, Corvinus University of Budapest
ID Code:2185
Deposited By: Ádám Hoffmann
Deposited On:05 Jan 2016 08:44
Last Modified:05 Jan 2016 09:14

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