Subsidizing Startups under Imperfect Information

Abstract: We study the early stages of firm creation under imperfect information. Because startups make error-prone decisions due to rational inattention, the model generates both inefficient entry and labor misallocation. We show that information frictions alter the effects of lump-sum transfers to startups: the total employment gain is amplified due to an unintended increase in inefficient entry, most entrants hire fewer workers, and misallocation goes up. The transfer makes low-size, previously dominated actions profitable, affecting the entire endogenous learning problem and making even productive startups lean toward more conservative hiring. We show that this novel information channel works against well-known mechanisms (for example, financial frictions) and also dampens the effects of alternative policies such as wage subsidies.

Keywords: startups; rational inattention; firm subsidy;

JEL Classification: D82; D83; E60; H25;

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Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2021-12-01

Number: 995