Success Breeds Success Locally: A Tale of Incubator Firms

Abstract:     
This paper considers a region in which some would-be entrepreneurs are in the network of a hub firm and the rest stand alone. Project ideas come in two types: good and not-so-good. Entrepreneurs need to borrow from banks or local financiers to start their projects. Local financiers receive a signal from the hub firm about the quality of the network entrepreneurs' projects. This improves the match of capital to ideas in the network even though the overall distribution of capital to ideas remains unchanged. Thus, a network's producing many successful entrepreneurs does not necessarily mean that the network is useful for the society. Yet, I show that there can be market incentives for the hub firm to decrease the information gap between entrepreneurs and local financiers (via a hub-signaling mechanism). When the network is large, all network entrepreneurs prefer the hub-signaling mechanism and are able to make side payments to the hub firm for that purpose. When the network is small, good network entrepreneurs prefer the hub-signaling mechanism whereas not-so-good network entrepreneurs prefer the status quo. Nonetheless, the former group's ability to make side payments is always higher than the latter group's. Thus, in both cases, the surplus created by the hub-signaling mechanism can be sufficient incentive to form it. This result extends to costly signaling, implying the possibility of inefficient agglomeration due to asymmetric information.

Keywords: entrepreneurship, established firms, local financiers, networks, start-ups

JEL Classifications: D82, G20, R12, L26

Working Paper Series