What makes an entrepreneur? -
University of Warwick institutional repository: http://go.warwick.ac.uk/wrap This paper is made available online in accordance with publisher policies. Please scroll down to view the document itself. Please refer to the repository record for this item and our policy information available from the repository home page for further information. To see the final version of this paper please visit the publisher���s website. Access to the published version may require a subscription. Author(s): David G. Blanchflower and Andrew J. Oswald Article Title: What Makes an Entrepreneur? Year of publication: 1998 Link to published version: http://dx.doi.org/10.1086/209881 Publisher statement:None
What Makes an Entrepreneur? David G. Blanchflower and Andrew J. Oswald Dartmouth College and NBER and Warwick University To appear in Journal of Labor Economics, 1998, 16(1), pp. 26-60 This is an extended and revised version of NBER Working Paper # 3252. We thank the ESRC and the UK Department of Employment for financial assistance. The project has had a long gestation period (the first version was circulated in 1988). Helpful suggestions were made by participants in seminars at Cambridge (UK), LSE, Harvard, Dartmouth, Aberdeen, Glasgow, Guelph, McMaster, Oxford, the London Business School, Swansea, Uppsala, FIEF (Stockholm), and Warwick, and by Peter Abell, Graham Beaver, Joan Beaver, Fran Blau, George Borjas, Mark Casson, Andrew Clark, Robert Cressy, Peter Elias, Roger Gordon, Al Gustman, Tom Holmes, Peter Johnson, Bruce Meyer, Chris Pissarides, Gavin Reid, David Storey, Steve Venti, Alex Zanello, and a referee.
Abstract The factors that affect the supply of entrepreneurs are important but poorly understood. We study a sample of individuals who choose either to be employees or to run their own businesses. Four conclusions emerge. First, consistent with the existence of borrowing constraints on potential entrepreneurs, we find that the probability of self-employment depends markedly upon whether the individual ever received an inheritance or gift. Second, when directly questioned in interview surveys, potential entrepreneurs say that raising capital is their principal problem. Third, consistent with our theoretical framework's predictions, the self-employed have higher levels of job and life satisfaction than employees. Fourth, childhood personality measurements and psychological test scores are of almost no help in predicting who runs their own business later in life. It is access to start-up capital that matters.
What Makes An Entrepreneur? " For many commentators this is the era of the entrepreneur. After years of neglect, those who start and manage their own businesses are viewed as popular heroes. They are seen as risk-takers and innovators who reject the relative security of employment in large organizations to create wealth and accumulate capital. Indeed, according to many, economic recovery ... is largely dependent upon their ambitions and efforts." (Robert Goffee and Richard Scase (1987), p.1.)) 1. Introduction Most Western governments provide encouragement and tax breaks to those who run small businesses. Politicians appear to believe that there are undesirable impediments to the market supply of entrepreneurship. Despite media and political interest in this topic, however, economists have contributed relatively little to the debate about how the economy generates successful small businesses. It has long been noted that economics textbooks largely ignore the role of the entrepreneur and say little about the formation of the small enterprises that provide the beginnings of giant corporations. The simplest kind of entrepreneurship is self-employment. There is recent survey evidence to suggest that, in the industrialized countries, many individuals who are currently employees would prefer to be self-employed. Although it cannot be definitive, this evidence suggests that there may be restrictions on the supply of entrepreneurs. The International Social Survey Programme of 1989 asked random samples of individuals from eleven countries the question: "Suppose you were working and could choose between different kinds of jobs. Which of the following would you choose? I would choose ... (i) Being an employee
2 (ii) Being self-employed (iii) Can't choose." Large numbers of people gave answer (ii) and thus stated that they would wish to be self-employed. This answer was given by, for example, a remarkable 63% of Americans (out of 1453 asked), 48% of Britons (out of 1297), and 49% of Germans (out of 1575). These numbers can be compared with an actual proportion of self-employed people in these countries of approximately 15%. The data raise a puzzle: why do not more of these individuals follow their apparent desire to run a business? This paper explores the factors that may be important in determining who becomes and remains an entrepreneur. After years of comparative neglect, research on the economics of entrepreneurship -- especially upon self-employment -- is beginning to expand. Microeconometric work includes Fuchs (1982) and Rees and Shah (1986), and more recently Pickles and O'Farrell (1987), Borjas and Bronars (1989), Evans and Jovanovic (1989), and Evans and Leighton (1989)(1). This paper follows in the general spirit of these inquiries, although its data and methods differ from those in earlier investigations. One possible impediment to entrepreneurship is lack of capital. In recent work using US micro data, Evans and Leighton (1989) and Evans and Jovanovic (1989) have argued formally that entrepreneurs face liquidity constraints. The authors use the National Longitudinal Survey of Young Men for 1966-1981 and the Current Population Surveys for 1968-1987. The key test shows that, all else equal, people with greater family assets are more likely to switch to self-employment from employment. This asset variable enters probit equations significantly and with a quadratic form. Although Evans and his collaborators draw the conclusion that capital and liquidity constraints bind, this claim is open to the objection that other interpretations of their correlation are feasible. One possibility, for example, is that inherently acquisitive individuals both start their own businesses and forego leisure
3 to build up family assets. In this case, there would be a correlation between family assets and movement into self-employment even if capital constraints did not exist. A second possibility is that the correlation between family assets and the movement to self-employment arises because children tend to inherit family firms. The paper provides, in Section 4, a new test of the finance-constraint hypothesis. The test uses data on inheritances and gifts (as though from a 'natural experiment' in which some people enjoy windfalls while most do not). Studying the behavior of those who receive money is presumably as close as the economist can get to the ideal laboratory experiment in which some subjects are issued with capital while those in a control group get none. Results described later show that individuals who have received inheritances or gifts are more likely to run their own businesses. This is true holding constant a group of personal, family and geographical characteristics. The effect is large, and is not the result of offspring inheriting family enterprises. The paper presents complementary questionnaire evidence. This is of a kind apparently not reported before in the literature. Data from interviews with random samples of individuals demonstrate that the self-employed say that they are constrained principally by a lack of capital. Moreover, many of those who are not self-employed say that it is predominantly a shortage of capital that prevents them from starting their own business. Section 5 contains this survey material. Although such survey responses have to be interpreted with caution, the message they provide is consistent with that from the quite different econometric methods. Another theme within the paper is the role of psychological characteristics. The analysis studies the correlation between the probability of being self-employed as an adult and the individual's childhood scores on a number of psychological tests. Although originally a major motivation for the research, the results are relatively poor. Individuals' psychology -- at least using the data available here --
4 does not play a large role. If it is true that capital and other constraints hold back the effective supply of entrepreneurship, and so lead to there being frustrated employees who would rather be entrepreneurs, those who run their own businesses might be expected to be 'happier', on average, than those who do not. In Section 6, the paper suggests and implements an econometric test of this hypothesis. It uses data of a kind more commonly studied by psychologists. 2. Theoretical Background Consider the following theoretical model in which people choose between working in the entrepreneurial sector and being an employee. First, assume, following Knight (1921) and others, that entrepreneurial opportunities cannot be assigned probabilities. Second, assume that entrepreneurs may be constrained in the amount of capital they can directly acquire. Consider person j, who by assumption is a potential business-person with the vision to see a range of feasible business projects, and thus is within the intrinsically entrepreneurial section of the population. He or she needs capital to undertake a project. One possibility is to use own or family funds, thereby making it unnecessary to borrow commercially. However, person j may have lower savings than are required for the entrepreneurial venture. Then there is no option but to try to obtain a business loan. A banker in the above framework is likely to reason in the following way. "I have little idea about whether project X will work out as Mr. A says. I cannot assign it a probability. However, if Mr. A offers me collateral of Y, then I can make a loan of Y - ��, where �� is the cost of reclaiming the collateral in the event of bankruptcy. This is effectively a risk-free loan." Thus secured ('collateralized') loans are a rational response by bankers to imperfect knowledge. Such a view provides a natural rationale for the existence of capital constraints. Assume individual j can get an unsecured loan only z percent of the time,
5 where z is below unity. This is despite the fact that the business venture is assumed sound. The reason for the apparent sub-optimality is that individual j has no way of assuring the typical banker that the hypothetical project is feasible. He may do so (perhaps because some within the innovative entrepreneurial class become bankers), but not with certainty. This approach makes genuine uncertainty a central feature of the analysis. By contrast, the recent work by Kanbur (1982), Khilstrom and Laffont (1979) and Grossman (1984) breaks with the tenets of earlier thought on entrepreneurial activity. Kanbur et al develop a standard neoclassical approach in which productive business opportunities are ex ante feasible for, and visible to, all individuals (most simply choose not to exploit them) there is an objective probability distribution governing business risk, and everyone knows that distribution entrepreneurs receive the same expected utility as their workers the entrepreneur is likely to be someone with unusually low risk-aversion (see especially Khilstrom and Laffont, 1979). These are different from the main assumptions and arguments of classic sources such as Schumpeter (1939), Knight (1921) and Kirzner (1973). In contrast to modern theory, the classic writings about the nature of the entrepreneur stressed the following: most individuals are not sufficiently alert or innovative to perceive business opportunities there is no objective probability distribution governing business risks an innovative entrepreneur may receive higher expected utility than he or she would as a regular worker attitude to risk is not the central characteristic that determines who becomes an entrepreneur. The paper's model draws upon the older, but recently neglected, current of thought. Eight assumptions are made. A.1 Assume that proportion �� of the population has entrepreneurial vision. This group of individuals can see business opportunities where proportion 1-�� see none. A.2 There is, in the economy, an array of viable entrepreneurial projects, each of
6 which requires a different amount of capital, k. Each project requires only one entrepreneur's labor. A.3 The profit from project k (indexing in this way without loss of generality) is p(k). This function describes the return from the different entrepreneurial ventures in the economy. Without loss of generality, it is assumed to be strictly increasing. A.4 There is a distribution of capital endowments across the population. Denote it f(k), defined on support [0, 1]. The latter normalizes the richest person's assets at unity. A.5 An individual who perceives the array of business opportunities cannot with certainty borrow the required capital unless he or she has access to the necessary collateral. This is because, by their nature, such opportunities are not within the vision of most other kinds of individuals (such as bankers approached for loans). The individual can try to borrow for a project, but has only probability z of obtaining an unsecured loan(2). A.6 Individuals receive utility u = p + i in self-employment u = w in conventional employment, where w is the wage paid for non-entrepreneurial work, and i is the non-pecuniary utility from being independent and "one's own boss". A.7 Anyone can find alternative work at wage w in the non-entrepreneurial part of the economy. It is assumed that w equals the marginal product of labor in that alternative sector, and that this is a declining function, w(N), of the number of employees in the sector, N. A.8 Population is normalized at unity. The number of entrepreneurs is E. These assumptions lead to a simple but fairly unconventional model. To make the key points as simply as possible, all probabilistic business risk is assumed away. Many potential entrepreneurs are liquidity-constrained. People enter
7 entrepreneurship until, in equilibrium, either (i) capital or vision constraints are binding in aggregate or (ii) the utility from running a business is driven down to equal to that from wage-work. In the latter case, w = p(k*) + i, (1) where k* is the amount of capital needed for the marginal entrepreneurial project. All projects requiring more capital have here already been undertaken. The number of entrepreneurs in the economy is E = �� f k dk + ��z k* 1 f k dk 0 k* (2) = 1 - N (3) This is also, by the choice of units, the probability of self-employment for one individual. The first term on the right-hand side of equation (2) is the probability of 'vision' multiplied by the number of people with a greater capital endowment than k* (that needed for the marginal project). The second term on the right-hand side of equation (2) is the probability of vision multiplied by the probability of successfully getting an unsecured business loan multiplied by the number of individuals who are short of capital. Equilibrium in this economy can take two different forms. One is described by the simultaneous solution of equations (1) to (3). This is the case in which the market for entrepreneurs clears: the marginal entrepreneur earns utility (made up of profit plus the satisfaction from independence) equal to that from working in the wage-sector. There is a second possibility, and that is when there are insufficient entrepreneurs to drive to zero the surplus from running the marginal business. When there is a shortage of ��-individuals with capital, p(k*) + i w. (4) This distortion is a result of the asymmetric information between bankers and individuals with entrepreneurial vision.
8 A number of obvious comparative static results emerge. Proposition 1 When the market for entrepreneurs clears (p(k*) + i = w), the following raise the equilibrium number of entrepreneurs and the economy's wage rate: (i) an increase in ��, the proportion of the population with (entrepreneurial) vision (ii) a rise in i, the utility from independence (iii) an increase in z, the probability of loans to individuals without sufficient capital. Proposition 2 When the market for entrepreneurs fails to clear (p(k*) + i w), the following raise the equilibrium number of entrepreneurs and the economy's wage rate: (i) an increase in ��, the proportion of the population with entrepreneurial vision (ii) an increase in z, the probability of loans to individuals without sufficient capital. (iii) a drop in k*, the binding level of capital necessary to set up a business Contrary to the market clearing case, (iv) the utility from independence, i, has no effect. The proofs are omitted (they are given in an earlier version that is available on request from the authors). The underlying i dea is a simple one. At the individual level, there are capital constraints. Some of the people with the ability to see good projects fail to obtain the funds to undertake them they do not have a large enough capital endowment, k, and are not lucky enough to get an unsecured loan. At the aggregate level, however, the capital constraint may not bind. This is the case analyzed in Proposition 1, where there is no distortion. The case in Proposition 2 is different. Here the supply of capital is so short that anyone who can raise the finance earns a form of rent created by the asymmetric information in the economy(3).
9 In equilibrium, either capital or vision constraints are binding in aggregate, or the utility from running a business has been driven down to equal that from wage-work. In the former case w p(e*) + i, and in the latter w = p(e*) + i. In a slight change of notation, for convenience, from capital levels to entrepreneurial projects, e* is denoted as the marginal entrepreneurial venture. At e*, all business projects with higher profitability (and higher capital) are already being undertaken. Entrepreneurs are better off than regular workers, and the mean gap in utility between the two kinds of work is higher if there are fewer numbers of people with capital. Proposition 3 Entrepreneurs get higher utility than regular workers. Proposition 4 When capital constraints bind, the larger is Z, the number of people in the economy who have capital, the smaller is the utility gap between entrepreneurs and workers. Proofs See Appendix. This framework suggests two testable hypotheses. The first is the idea that some potential entrepreneurs are constrained, by lack of access to capital, to become employees rather entrepreneurs. The second is that individuals who run their own enterprises have higher utility than those who are employees in the wage- sector. Sections 3 and 4 study the first issue using an econometric test and complementary questionnaire evidence. The second issue is intrinsically more difficult to assess, because it requires data on utility levels in the two sectors. Following methods more commonly found in psychology than economics, Section 5 implements a test using reported satisfaction levels as proxy utility data. 3. Data and Methods Whether or not individual j is self-employed depends on a joint probability
10 captured by the constituent parts of equation (1): the probability of running a business = (the probability of having entrepreneurial vision) * (the probability of having capital + the probability of being able to get an unsecured loan given no capital). Empirically these probabilities may be assumed to depend upon a set of personal characteristics, especially measures correlated with the person's assets, and a set of regional and industrial characteristics. Rather than work with a highly structured model, the paper estimates reduced-form equations based on a linearization of the assumed probability function, and uses standard personal variables plus a range of childhood variables. Should the analysis focus upon transitions into self-employment or upon cross-section evidence on those who are self-employed? Although it would be useful to have results for pure transitions into self-employment, there is a problem with such an approach. Policy-makers (as well as economists) are interested in entrepreneurs who are successful rather than unsuccessful, and in small businesses that last rather than fail. Therefore, showing that inheritances affect the flow into entrepreneurship would, in itself, be of limited (though positive) value, for it could be that such individuals quickly exit from self-employment. Establishing that a person's access to finance influences his or her decision to remain self-employed would, similarly, also be of positive but limited interest, because such people might be less likely to flow in to entrepreneurship in the first place. A natural way to learn about the aggregate influence of capital injections such as inheritances is thus either (i) simultaneously to study both sets of transitions (in and out), or (ii) to study the effects of earlier inheritances upon the cross-section probability of being self-employed. This paper -- partly because of the nature of the data -- adopts the second approach. New work by Holtz-Eakin et al (1994a,b),
11 which follows an early version of this paper, takes route (i) and shows that inheritances both raise entry and slow exit. The econometric analysis described in the next section draws upon the National Child Development Study (NCDS). This is a longitudinal birth cohort study that takes as its subjects all those living in Great Britain who were born between the 3rd and the 9th March, 1958. These children were surveyed at birth, and at ages 7, 11, 16, 23, and 33. At each of the first three follow-ups, information was obtained from parents, teachers, and doctors. At the most recent sweep, conducted in 1991 when all subjects were age 33, information was also gathered about the respondent's spouse and children. For details of the survey design, see Elias and Blanchflower (1989). We make use of information about employment status that was collected in the interviews of 1981 (NCDS4) and 1991 (NCDS5). This has the useful feature that it provides snapshots of self-employment activity when the individuals were in their early twenties and early thirties. The 1981 sweep of NCDS contained 12,537 interviews. Of the total, 521 were self-employed, while 8657 worked as employees. Hence, approximately one in eighteen young people who were working at the time of interview had a job which they had, in a sense, created themselves. The 1991 sweep contains data on 11,407 individuals. Of these, 1279 were self-employed, while a further 7703 were employees. Thus, ten years further into the life cycle, the proportion of employment accounted for by the self-employed had risen from 5.7% in 1981 to 14.2% in 1991. The period itself probably accounts for some of this rise. In December 1981, there were 21,142,000 employees in employment in Great Britain, of whom 2,093,000 or 9.9% were self-employed. This compares with 21,506,000 employees in employment in December 1991, of whom 3,224,000 or 15% were self-employed (Source: Employment Gazette, January 1985, May 1994). The empirical analysis focuses on individuals who were either employed or
12 self-employed at the time of interview in either 1981 or 1991. In each year, we study cross-section patterns at that point in time. This makes the nature of the equations different from Evans's work with Jovanovic and Leighton, where the data were on the flow into self-employment. The paper studies the probability that an individual reports himself or herself as self-employed. The dependent variable is therefore a stock rather than a flow, and so captures the combined effects of gifts and inheritances (among other variables) on past movements into and out of self- employment. However, some information is available on timing, and the later results do more than look at simple cross-section correlations. To produce plausible evidence that an access-to-capital variable influences entrepreneurial activity, it is necessary to have a well-designed statistical test. It is likely to be important to be able to argue that the capital variable is exogenous or can be instrumented convincingly. Two tests are done on 1981 data. One uses instrumental variables, the other lags. The data set has the valuable feature that it records in 1981 whether or not the entrepreneur's parents are alive or dead. A variable for parental death then makes a natural instrumental variable (in the NCDS data set, approximately 14% of individuals have at least one parent who has died), because it should enter an inheritance equation but not a self-employment equation. Unfortunately, this cannot be done in the 1991 data, because parental death is not available in the later data. In order to provide an additional test of the direction of causality, the paper also uses data on gifts/inheritances that were received many years before the start- up decision. The key question in the NCDS surveys is: "Have you (or your husband/wife/partner) ever inherited, or received as a gift from another person, money, property, or other goods to the value of ��500 or more?" Q. 9, p. 68, NCDS4 and Q.E11, p.71, NCDS5.