FUND SUBSTITUTION AND THE INCENTIVE EFFECT OF PUBLIC-INVESTMENT SUBSIDIES

This paper analyses the observed phenomenon of public for private fund substitution in industrial assistance, by examining the public and pr ivate sector funding of investment under different assumptions about t he nature of the private capital marker. This bears an the effectivene ss of industrial subsidies, and has implications for welfare and the d esign of optimal assistance contracts. It is shown that fund substitut ion depends crucially on the elasticity of investment with respect to the user cost of capital in the without-subsidy position, and on the n ature of any amount and rate constraints on the assistance contract.