Government R&D subsidies as a signal for private investors

Government subsidies for R&D are intended to promote projects with high returns to society but too little private returns to be beneficial for private investors. This may be caused by spillovers or a low appropriability rate. Apart from the direct funding of these projects, government grants may serve as a signal for good investments for private investors. We use a simple signaling model with different types of R&D projects to capture this phenomenon. The agency has a preference for basic research projects as they promise high expected social returns, while banks prefer applied research projects with high private returns. In a setup where the subsidy can only be used to distinguish between basic and applied research projects, government agency’s signal is not very helpful for banks. However, if the subsidy is accompanied by a quality signal, it can lead to increased or better selected private investments.