Who Becomes an Entrepreneur? Labor Market Prospects and Occupational Choice

Why do some people become entrepreneurs (and others don't)? Why are firms so heterogeneous, and many firms so small? To start, the paper briefly documents evidence from the empirical literature that the relationship between entrepreneurship and education is Ushaped; that many entrepreneurs start a firm "out of necessity"; that most firms are small, remain so, yet persist in the market; and that returns to entrepreneurship have a much larger cross-sectional variance than returns to wage work. Popular models of firm heterogeneity cannot easily account for the U-shape or for the persistence of low-productivity firms. The paper shows that these facts can be explained in a dynamic model of occupational choice between wage work and entrepreneurship where agents are heterogeneous in their ability as workers, and starting entrepreneurs face uncertainty about their project's productivity. Then, under weak conditions, the most and the least able individuals choose to become entrepreneurs. This sorting is due to heterogeneous outside options in the labor market. Because of their low opportunity cost, low-ability agents optimally spend more time searching for a good project. This also makes them more likely to abandon an unsatisfactory project for a new one. Data from the National Longitudinal Survey of Youth (NLSY79) give support to these two predictions. Individuals with relatively high or low ability are more likely to be entrepreneurs or to become entrepreneurs, and spend more time in entrepreneurship. Low-ability entrepreneurs are more likely to abandon a project after only a year.