Asymmetric Information, Entrepreneurial Activity, and the Scope of Fiscal Policy in an Open Regional Economy

Abstract

The authors analyze two hitherto little studied but salient questions concerning the trinity of asymmetric information, entrepreneurial activity, and the scope of fiscal policy in an open regional economy. First, the authors use a two-period model to analyze the contractual relationship between entrepreneurs and venture capitalists when the latter are located outside the region. Because there is moral hazard, venture capitalists do not offer entrepreneurs the first best investment contract and entrepreneurial activity is suboptimal. Second, they analyze a two-period model with venture capitalists who are now located inside the regional economy. They show that despite the existence of a credit market imperfection, because, inter alia, the regional authority (RA) does not have an informational advantage over the private sector, it is not possible for this RA to use fiscal policy to make a Pareto improving intervention in which some agents are better off and others are no worse off.