Migration, Wages, and Parental Background: Obstacles to Entrepreneurship and Growth in East Germany

East Germany's unemployment rate still doubles that of West Germany and for the last decade its economic growth has been below that of other transition countries. Policy makers often point to the lack of entrepreneurship as one of East Germany's main problems. This paper addresses the question of how East Germany's integration into an established economy, West Germany, may have hindered a fruitful development of entrepreneurship and how this may have affected economic growth. I build a model economy that places Lucas' (1978) span-of-control model into an overlapping-generations framework. Following Hassler and Rodríguez Mora (2000) managerial knowhow is defined as a combination of two factors, innate talent and entrepreneurial parental background. Furthermore, growth depends only on the innate talent of entrepreneurs. In East Germany, the lack of entrepreneurial parental background makes innate talent the decisive factor in occupational choice and more talented entrepreneurs should contribute to high growth rates. However, three key aspects of its integration into West Germany inhibit this mechanism: migration possibilities to West Germany, the way East German wages were regulated upon reunification and the importance of parental background for entrepreneurship in West Germany. Counterfactual experiments show that eliminating any of these three aspects leads to more entrepreneurs, less unemployment, and higher economic growth in East Germany.