Occupational Choice, Incentives and Wealth Distribution

We consider a model of endogenous occupational choice in economies with a continuum of individuals who differ in their wealth endowments. Individuals have a choice of remaining self-employed or engaging in productive matches with other individuals, i.e., forming firms. Such frictionless matches are subject to a hidden-action moral hazard problem with a limited liability constraint. This leads to wealth effetc and the payoff-relevance of wealth differences across individuals. We suppose that the division of the gains from such matches is endogenous and determined by competitive market forces. Contracts are chosen optimally within matches subject to the market determined division of the gains from matching. We show that when financial markets are perfect the equilibrium distributions of occupations, utilities and surplus typically depend on the distribution of wealth in the economy if and only if some limited liability constraints bind in equilibrium. When financial markets are imperfect however, the equilibrium might involve the economy segregating into a high-surplus rich sector and a low-surplus poor sector, independent of the distribution of wealth in the economy. We characterize the nature of the equilibrium as a function of the nature (symmetry) of the underlying agency problem within a firm and of financial market imperfections.