Entrepreneurial Risk, Investment and Innovation

A number of studies show that entrepreneurial households face a large amount of unvidersifiable risk. This paper studies the effects of this risk on the relationship between uncertainty, innovation and investment dynamics. In the first part of the paper we develop a simple model of a risk averse entrepreneurial household that can invest in a risky technology or in a risk free asset. The idiosyncratic risk of the technology is not insurable. We calibrate the model so that a simulated industry of entrepreneurial households matches the cross sectional volatility of profits and the distribution of the concentration of wealth (the percentage of net worth that each entrepreneurial household invests in their own business) across US entrepreneurial households. We show that, due to the lack of diversification, a small increase in uncertainty has a large negative effect on the investment decisions of entrepreneurial firms. Given that entrepreneurial firms are on average much smaller than publicly owned firms, this result provides a plausible explanation of the findings of Ghosal and Loungani (2000), who show that the negative impact of uncertainty on investment is much greater in US industries dominated by small firms than in those dominated by large firms. In the second part of the paper we study a unique dataset of italian manufacturing firms with both information about the property structure and about the type of investment performed by the firms. We show that an increase in uncertainty negatively affects the investment in innovation of entrepreneurial firms, while it does not affect the investment in innovation of non entrepreneurial firms