How to Motivate Fundamental Innovation: Optimal Interactions between Entrepreneurs, Venture Capitalists, and the Government

We analyze the roles of entrepreneurs, venture capitalists (VC), and the government in financing fundamental innovations, defined as those with positive social value net of development costs, but negative net present values to innovating firms. We first analyze the case where the entrepreneur, with or without VC financing, develops innovations. We then analyze government support of innovation and the government's optimal choice between subsidies and innovation prizes. We also analyze the optimal interactions between government subsidies and VC financing, and show that it is optimal for the government to channel subsidies partially through VCs, providing a rationale for government-funded VCs.