Financial Contracts and Occupational Choice

Financial constraints and entrepreneurship are among the key factors affecting economic performance in developing countries. Emphasizing the link between the theory microfoundations and the data, the paper considers a heterogeneous agents model of occupational choice with moral hazard under three Þnancial contract regimes differing in their degree of market incompleteness: savings only, borrowing and lending, and insurance. Using maximum likelihood estimation and statistical model comparison methods, I Þnd evidence that the more advanced Þnancial contract regimes allowing for borrowing or insurance provide a better Þt with cross-sectional and time-series data from Thailand compared to the savings only regime. However, a direct comparison between the borrowing and lending and insurance regimes shows that neither of them can be rejected in favor of the other relative to the data. Augmenting the contracts with wealth-pooling lottery redistribution arrangements improves further the explanatory power of the model. A new numerical solution technique for incentive-constrained occupational choice models based on non-linear optimization is also proposed. ∗Comments from Francisco Buera, Laurent Calvet, Pierre-Andre Chiappori, Pierre Dubois, Maitreesh Ghatak, Roger Myerson, Phillip Reny and from participants in the theory and development working group at the University of Chicago and the 2002 NEUDC conference are gratefully acknowledged. I am much indebted to Robert Townsend for extensive discussions and for his permission to use his Thailand project data in this paper.