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Topic 4: Entrepreneurship and Household Behavior

Topic 4: Entrepreneurship and Household Behavior

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Topic 4: Entrepreneurship and Household Behavior

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  1. Topic 4:Entrepreneurship and Household Behavior

  2. Four Broad Questions I Want Us To Cover 1. How Important are Liquidity Constraints to Small Businesses? 2. How much do ex-ante differences in motivations to start a small business explain differences in ex-post small business outcomes? o Subtitle: Is it correct to equate small business owners with “entrepreneurs”? How Important are Non-Pecuniary Benefits In Explaining the Behavior of Small Businesses? o At a minimum, how should one think about small business dynamics in a world where non-pecuniary benefits are important? 4. To What Extent Do the Self Employed Lie About Their Earnings To Household Surveys ? o Subtitle: Can we trust the income data in household surveys?

  3. Part 1:Liquidity Constraints and Small Business Formation(Some Theory)

  4. Why Do People Start Businesses? Small Business Skills (Innovators) (Schumpter (1934), Evans and Jovanovic (1989)) Risk Preferences (Kihlstorm and Laffont (1979), Jovanovic (1979)) “Jack of All Trades” (have better management skills) (Lazear (2005)) Two major questions in the literature: Why can’t innovation take place in the existing firms? Can the new firms get financing?

  5. Household Choice: Become a worker: Earn wage: (wζ) Become an “entrepreneur”: Earn income: ( ) where: θ is entrepreneurial ability (known when making choice) k is capital necessary to start a business α is returns to scale on capital: Note: Assume innovations to w and y are uncorrelated. Assume that ability (θ) is uncorrelated with market wage. Assume risk neutrality. Static model: People are endowed with initial wealth z. Evans and Jovanovic (1989)

  6. Total entrepreneurial income: • where: z is initial wealth • Constraint: • Firms can at most borrow λ times their initial wealth to fund their capital project. • Note: Borrowing rate = lending rate = r (same for everyone). Evans and Jovanovic (1989)

  7. Choice of Optimal Entrepreneurial Capital Stock

  8. Entrepreneurial Income as a function of constrained/unconstrained k. Finish Solving The Model: Part 1

  9. Finish Solving the Model: Part 2Compare Entrepreneurial Earnings to Wages

  10. Implication of the Model:Probability of Entrepreneurship Increasing in Wealth

  11. Richer households are less bound by liquidity constraints and as a result • are more likely to enter entrepreneurship. • Should see a positive relationship between initial wealth and entry into • small business ownership. Evans and Jovanovic Conclusions

  12. Part 2:Wealth, Tastes and Entrepreneurial Choice(Some More Theory)

  13. In this paper, ….. We formally show that the existence of non pecuniary benefits can: o Inform expectations about the relationship between initial household wealth and business entry decisions (in a world with no liquidity constraints). o Inform expectations about the distribution of firm size. o Inform expectations about the occupations/industries where one should see a high concentration of employment in small business firms. o Inform expectations about the level of non-pecuniary benefits of small business ownership and the level of aggregate labor productivity. o Inform expectations about the welfare and productivity costs of small business subsidies (including distributional implications).

  14. A Model of Occupational Choice with Non Pecuniary Benefits (Pugsley 2012a) Static general equilibrium model Many households differ by initial endowment of wealth (y) and preferences for running their own business (γ), distributed F(y,γ) γ can be thought of as the size of the household’s non-pecuniary benefits from running their own business. Households have separable preferences over consumption and business ownerships such that: Households supply labor inelastically to a common labor market or to their own business (E).

  15. Final and Intermediate Goods Final good produced from many differentiated intermediates, Intermediates my be supplied by firms with following technology: Or, may be supplied by self employed with following technology: Note: Both sectors have same technology. Firm sector hires labor (h) such that h > 1.

  16. Firm’s Problem A firm producing b hires labor to maximize profits and may freely enter or exit the market. Free entry pins down the size of the firm: produce at minimum efficient scale low b high b small scale firm larger scale firm Assumption ensures U-shaped average cost curves for firms.

  17. Firm Production b Average Cost bhigh blow AC(bhigh) AC(blow) N(blow) N(bhigh) N

  18. Household’s Problem Facing w (equilibrium wage) and pb (price of good b sold by firms), household has two choices: o Decide whether to work at a firm or run their own business. o If running a business, what b should they produce/sell. For simplicity of narrative, assume that households can only allocate labor to either self employed sector or the firm sector. We could allow fractional time to both and everything would go through. To complete the markets with this assumption, we follow Rogerson (1988) and introduce lotteries. Basically, households choose probability E of starting a business to maximize: (full expenditure) = (full income)

  19. Some Comments 1. Non Pecuniary Benefits o Benefits come from being in a small firm (not running a firm). o To highlight the mechanism, we focus on an extreme notion of small (being self employed with no employees). o Could easily extend this to make the non pecuniary benefits diminish with firm size that one owns. o Could easily extend this to make non pecuniary benefits for being a worker in a firm diminish with the size of the firm. 2. Heterogeneity in ability o To highlight mechanism, shut down any heterogeneity in ability (both in self employed and firm sector).

  20. Model Trade-Off Benefits of small business ownership o Get utility of running a small business Costs of small business ownership o Forgo benefits of agglomeration o Implies lower wages associated with production o The lower wages reduce utility more for individuals with low wealth.

  21. Close the Model Unit measure of households Define price of final good, P: Normalize P = 1 Conditional demand functions:

  22. Two Sector Competitive Equilibrium Given a household distribution Ψ(y|γ)F(γ), a two-sector competitive equilibrium is: A small business sector b < b*, and a firm sector b ≥ b* Households with wealth y > y1(γ) run the business Given y and γ, probability Eyγ of starting a business: P{Start Business | y, γ} Entrepreneur households indifferent over b < b* and income pbfb(1) = z for all b < b*. Wage gap w-z > 0 is the pecuniary opportunity cost of running a business.

  23. Implication 1: Small Business Sector Concentrated in a Few Industries Explore this implication later in the lecture. We will see that small business activity is concentrated in a few industries. Those goods that are produced using a low returns to scale technology will be dominated by very small firms. The more important are non pecuniary benefits in utility, the more industries dominated by small firms.

  24. Implication 2: Skews the distribution of firms towards smaller firms

  25. Implication 3: Wages and Firm Size Model predicts: Small business owners will earn less than wage workers, wage workers in the firm. Intuition: Some of the compensation will be taken in the non- pecuniary benefits. Importance: Discussed more in latter part of the lecture. Growing body of evidence suggesting that small business owners earn less than what they would have earned had they stayed as a worker!

  26. Implication 3 (continued): Productivity and Non-Pecuniary Benefits

  27. Implication 4: Wealth and Business Ownership

  28. Implication 4: Wealth and Business Ownership Importance: o HUGE literature using the relationship between wealth and entry into business ownership as evidence of liquidity constraints. Cagetti and DeNardi ; Buera ; Evans and Jovanovic ; Quadrini o The existence of non pecuniary benefits can undermine this type of empirical strategy to test for the importance of liquidity constraints as a deterrent to small business formation. o Can use additional moments from data (i.e., wage gaps between wage and salary workers) to help tease out non-pecuniary benefits from liquidity constraints (Pugsley 2012b)

  29. One More Implication: A Policy Experiment In order to assess the total and distribution impacts of small business subsidies, need to add a government sector to the model. Suppose, governments provide subsidy s to small business “output”. Fund the subsidy with lump sum taxes, T (to start). Amend the budget constraint of households and add a balanced government budget constraint.

  30. Implication 5: Small Business Subsidies and Aggregate Productivity

  31. Implication 6a: Small Business Subsidies and Distributional Impacts • Small business subsidies in such a model are regressive!

  32. Implication 6b: Small Business Subsidies and Distributional Impacts Effect of increasing subsidy on welfare by income type – compensated differential (10% subsidy). Subsidy funded by proportional wealth tax.

  33. Some Conclusions So Far A positive relationship between business ownership and wealth could: o be a symptom that liquidity constraints are binding o be the result of the existence of non-pecuniary benefits in small business ownership. Where is the literature with respect to these questions? Is there conclusive evidence that liquidity constraints are a binding deterrent to small business activity? Is there conclusive evidence that non-pecuniary benefits are an important part of small business start up motivations? We will turn to these questions now…..

  34. Part 3:“Testing” for the Importance of Liquidity Constraints

  35. Old School Tests of Liquidity Constraints for Entrepreneurs Basically, the majority of empirical papers regress business ownership (the propensity to become a business owner, the propensity to survive as a business owner) on household wealth. Prob (Start Business (t, t+1)) = α0 + α1ln(Wealth(t)) + γ X + ε Early research concluded that if wealth is significant in predicting business entry, liquidity constraints are binding. (i.e., α1 > 0) Approach taken: Evans and Jovanovic (1989, JPE) Evans and Leighton (1989, AER) Fairlie (1999, Journal of Labor Economics) Quadrini (1999, Review of Income and Wealth)

  36. Limitations of “Old School” Approach The level of wealth is an endogenous variable. Are the factors that cause wealth accumulation orthogonal to entrepreneurial entry? o High ability earn more (accumulate more for retirement) and may be better at innovating. o Risk preferences can cause high wealth and taste for entrepreneurship o People planning for self employment accumulate assets for their retirement (do not have pensions). Next Generation of Studies: o Try to find an “instrument” for changes in household wealth. Note: These studies still do not attempt to distinguish between non- pecuniary benefits and liquidity constraints.

  37. Next Generation: “Inheritances” as an Instrument • Instrument for wealth - look at liquidity windfalls which are uncorrelated with the decision to become an entrepreneur. o Many use inheritances as instrument. o Find inheritances are strongly correlated with entrepreneurial entry. o Receiving an inheritance in year t predicts entrepreneurial entry between t and t+k. • Holz-Eakin, Joulfaian, and Rosen (JPE, 1994) • Blanchflower and Oswald (1998, Journal of Labor Economics).

  38. Up Though 2003: Conventional Wisdom • Liquidity constraints are an important deterrent to small business formation. • Liquidity constraints to small business formation is an important explanation of the dispersion in wealth (rich people keep accumulating wealth to relax their liquidity constraint for their small business). o Cagetti and DeNardi (2006, JPE). • Welfare costs of liquidity constraints to entrepreneurship is large o Buera (2009, Annals of Finance) Note: Both papers use as the basis of their models, the relationship between wealth and starting a business using household micro data.

  39. Hurst and Lusardi (2003)“Liquidity Constraints, Wealth, and Entrepreneurship” Goal of Paper o Are people interpreting the data correctly? o Do the relationships in the data point to evidence of liquidity constraints? Conclusion o The existence of binding liquidity constraints as a deterrent to small business activity is still very much an open question. o This research (and some other stuff I will show later) suggest that it will be hard to find evidence of binding liquidity constraints in household datasets.

  40. Some Facts About Small Business Owners • How much money do small business owners need to start their business? • 1987 NSSBF: Median amount of capital to start a business is $22,700 25% start with less than $5,000 • 1982 Characteristics of Business Owners (Meyer 1990) report even smaller figures: • 63% of non minority males and 78% of black business owners started with less than $8,700 (1996 dollars) • Inc Magazine 500 fastest growing companies in the U.S. (Bhidé 2000) • 26% started with less than $5,000 in upfront capital • Median was not much higher.

  41. What We Do in this Paper • Formally Test The Importance of Liquidity Constraints and Business Ownership • Examine the relationship between own wealth and business entry • Examine the relationship between parental wealth and business entry • Look at the wealth/business entry relationship by types of business • Instruments for wealth changes • Inheritances • Capital gains on housing. • Look at survival probabilities

  42. Data Source • Panel Study of Income Dynamics (PSID) • Can follow households in and out of business ownership. Business ownership is asked in every year. Business wealth (and all other wealth) asked every five years starting in 1984. • Main sample of analysis focuses: Stacked panel: Transition into business ownership between 1989 and 1990 and Transition into business ownership between 1994 and 1995 Focus on: Non business owners Households aged 22 to 60 Sample size: 7,645 observations (almost 5,000 distinct households). For some analysis, we will only use the 1989-1990 panel (occupation and industry codes are not available beyond 1993). 3,645 observations.

  43. Simple Initial Methodology • Run three different types of regressions Prob (Start Business (t, t+1)) = α0 + α1 Wealth(t) + γ X + ε Prob (Start Business (t, t+1)) = α0 + α1 Wealth(t) + α2 Wealth(t)2 + α3 Wealth(t)3 + α4 Wealth(t)4 + α5 lnWealth(t)5 + γ X + ε Prob (Start Business (t, t+1)) = α0 + α1 Dummy_Wealth_80-95 + α2 Dummy_Wealth_95+ γ X + ε • X includes controls for age, education, income, family structure, prior employment status, and prior business ownership. • Wealth is defined as the sum of savings and checking accounts, bonds, stocks, IRAs, housing equity, other real estate, and vehicles, minus all debts.

  44. Importance of Parental Wealth

  45. Wealth and Business Start Up by Industry • Wealth should be more important for starting a business with high starting capital requirements. • You need to be rich to start a car factory. However, wealth should not matter much to start a house-cleaning business. We explore heterogeneity in starting businesses of differing starting capital amounts. Perhaps the heterogeneity is masking evidence that liquidity constraints exist. Create Two Categories: • Low Starting Capital (Construction and Services) • High Starting Capital (FIRE, Manufacturing, Transportation, Wholesale and Retail Trade, Communications) Note: PSID has two additional industries: Farming and Professionals We will look at professionals separately

  46. What about Inheritances as an Instrument? • Fact is replicated in our data set. Is the case closed? No…… Why? • Many business are transferred at the time of death (5% of NSSBF sample) • More importantly, inheritances are not randomly distributed in the population. Those who get inheritances are just different (on average) from those who do not. A counterfactual…… Test of the latter proposition  Do future inheritances (received after the business is started) predict current business entry?