Who Works for Whom? Worker Sorting in a Model of Entrepreneurship with Heterogeneous Labor Markets

Compared with mature firms, young firms, most of which represent entrepreneurial activity, disproportionately hire younger, nonemployed individuals, and provide them with lower earnings. Furthermore, in recent years the number of young firms has been declining, along with their employment share, employee size, and worker earnings. To account for these facts, this paper introduces heterogeneous labor markets with search frictions to a dynamic model of entrepreneurship. Individuals differ in productivity and wealth. They can choose not to work, become entrepreneurs, or work in one of two sectors: a corporate versus an entrepreneurial sector. The differences in production technology and labor market frictions across the sectors lead to sector-specific wages. Worker sorting across sectors arises, as individuals with lower assets and higher productivity tend to take lower-paying jobs in the entrepreneurial sector because they do not have enough savings to smooth consumption while unemployed until the arrival of a higher-paying corporate sector job offer. This sorting is found to be consistent with the data on the average net worth of workers in young versus mature firms. The model is also used to explore potential mechanisms behind the recent decline in entrepreneurship in the U.S.