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Review of Economic Studies, 65(1):151-164, January, 1998
Because of the inherent uncertainty, promotion of innovation critically depends on the screening mechanisms to select projects. This paper studies the relationship between bureaucracy and financial constraints as two such mechanisms. The lack of commitment to hard financial constraints interferes with its ex post screening capability; ex ante bureaucratic screening is optimally chosen as a substitute. However, bureaucracy makes mistakes by rejecting promising projects and delays innovation, and the efficiency loss due to soft financial constraints increases as prior knowledge becomes worse and as research stage investment requirements become lower. In a centralized economy, bureaucracy may reduce the number of parallel projects, particularly for projects with higher uncertainties and less research stage requirements. This theory fits much evidence and in particular it explains why the computer industry, but not nuclear or aerospace industry, has fared so poorly in centralized economies.