Occupational Choice and the Quality of Entrepreneurs

This paper focuses on the quality of entrepreneurs when individuals, who di¤er in terms of entrepreneurial ability and wealth, choose between entrepreneurship and wage-earning. A loan is required to become an entrepreneur. Four wealth classes form endogenously. Banks’ inability to identify the ability of individuals leads them to o¤er pooling contracts to the poor and the lower-middle classes. Regardless of ability, all poor class individuals become workers and all lower-middle class individuals become entrepreneurs. Banks are able to o¤er separating contracts to the upper-middle and the rich classes. High-ability individuals in these wealth classes become entrepreneurs and their low-ability counterparts become workers. Equilibrium contracts may entail cross-subsidies within or between occupations. In some economies, a small success tax on entrepreneurs used to subsidize workers can increase the average quality of entrepreneurs and welfare by changing the thresholds of the wealth classes. In some others a reverse policy is required. Since the aggregate level of investment is …xed, the reason for these policies is not underor overinvestment by entrepreneurs, as it often is in previous literature. Keywords: adverse selection; entrepreneurship; general equilibrium contract theory; moral hazard; occupational choice; success tax; wage subsidy JEL Classi…cation: D43; D82; H25; L26 Tel.: 1-617-552-3670; fax : 1-617-552-2308. Address: Boston College, Department of Economics, 140 Commonwealth Avenue, Chestnut Hill MA 02467-3806 USA. E-mail address: [email protected]. I am grateful to David de Meza, Avinash Dixit, Nobuhiro Kiyotaki, Tomas Sjostrom, Hi-Lin Tan, the dissertation workshop participants at Boston College (2005, 2005, 2006, 2006), session participants at the CEBR Conference on Entrepreneurship: Occupational Choice and Financing (2006), the Cambridge-MIT Institute Workshop on Regional Innovation (2006), the European Meeting of the Econometric Society (2006), seminar participants at the Center for European Economic Research (ZEW) (2006), the University of Aberdeen (2007), Bilkent University (2007), Sabanci University (2007), the Norwegian School of Economics and Business Administration (2007), Georgia Institute of Technology (2007), the University of Mannheim (2006, 2007), Boston University (2006), and especially James Anderson, Richard Arnott, Susanto Basu, and Andrew Newman for helpful comments. Some of the ideas presented here were developed while I was attending three NBER Entrepreneurship Group Meetings in 2005. This research is …nancially supported by the Paula and Daniel Greeley Award and the Boston College Dissertation Fellowship Award. The travel grants given by the NBER Entrepreneurship Group and the Cambridge-MIT Institute are also gratefully acknowledged. All errors are mine.