Business Start-Ups and Productive Efficiency

This paper studies efficient allocation of resources in an economy in which agents are initially heterogeneous with regard to their wealth levels and whether they have ideas or not. An agent with an idea can start a business that generates random returns. Agents have private information about (1) their initial types, (2) how they allocate their resources, and (3) the realized returns. The unobservability of returns creates a novel motive for subsidizing agents who have ideas but lack resources to invest in them. To analyze this motive in isolation, the paper assumes that agents are risk-neutral and abstracts away from equality and insurance considerations. The unobservability of initial types and actions implies that the subsidy that poor agents with ideas receive is limited by incentive compatibility: the society should provide other agents with enough incentives so that they do not claim to be poor and have ideas. The paper then provides an implementation of the constrained-efficient allocation in an incomplete markets setup that is similar to the U.S. Small Business Administration’s Business Loan Program. Finally, the paper extends the model in several dimensions to show that the results are robust to these generalizations of the model. ∗Yazici, University of Minnesota and Federal Reserve Bank of Minneapolis. I am especially grateful to Narayana Kocherlakota and Chris Phelan for their valuable advice and encouragement throughout the project. I also want to thank Cristina Arellano, V.V. Chari, John T. Dalton, Seda Ertac, Kenichi Fukushima, Turkmen Goksel, Larry E. Jones, Patrick Kehoe, Tommy Leung, Fabrizio Perri, Paul Povel, Adam Slawski, Richard Todd, Cengiz Yazici, Kuzey Yilmaz, the members of the Public Economics workshop at the University of Minnesota, and seminar participants at the Federal Reserve Bank of Minneapolis and the SED meetings in Cambridge for their comments and suggestions. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.