Fund Substitution and the Incentive Effect of Public Investment Subsidies.

This paper analyzes the observed phenomenon of public for private fund substitution in industrial assistance by examing the public and private sector funding of investment under different assumptions about the nature of the private capital market. This bears on the effectiveness of industrial subsidies but also has implications for welfare and the design of optimal assistance contracts. The assistance contract involves both assistance rate and amount constraints, and it is shown that fund substitution depends crucially on the nature of these constraints and on the elasticity of investment with respect to the user cost of capital in the without-subsidy position. Copyright 1996 by Scottish Economic Society.