Module 2 reading list

Capital constraints

Blanchflower, D.G. and Oswald, A.J. (1998) ‘What Makes an Entrepreneur?’, Journal of Labor Economics, 16(1), pp. 26–60.

This article uses various micro data sets to study entrepreneurship. Consistent with the existence of capital constraints on potential entrepreneurs, the estimates imply that the probability of self-employment depends positively upon whether the individual ever received an inheritance or gift. When directly questioned in interview surveys, potential entrepreneurs say that raising capital is their principal problem. Consistent with our theoretical model’s predictions, the selfemployed report higher levels of job and life satisfaction than employees. Childhood psychological test scores, however, are not strongly correlated with later self-employment.

Cagetti, Marco, and Mariacristina De Nardi. “Entrepreneurship, frictions, and wealth.” Journal of political Economy 114.5 (2006): 835-870.

Although the role of financial constraints on entrepreneurial choices has received considerable attention, the effects of these constraints on aggregate capital accumulation and wealth inequality are less known. Entrepreneurship is an important determinant of capital accumulation and wealth concentration and, conversely, the distribution of wealth affects entrepreneurial choices in presence of borrowing constraints. We construct a model that matches wealth inequality very well, for both entrepreneurs and non-entrepreneurs. We find that more restrictive borrowing constraints generate less wealth concentration, but also reduce average firm size, aggregate capital, and the fraction of entrepreneurs. We also find that voluntary bequests are an important channel that allows some high-ability workers to establish or enlarge an entrepreneurial activity: with accidental bequests only, there would be fewer large firms, fewer entrepreneurs, and less aggregate capital, but also less wealth concentration.

Evans, D.S. and Jovanovic, B. (1989) ‘An Estimated Model of Entrepreneurial Choice under Liquidity Constraints’, Journal of Political Economy, 97(4), pp. 808–827.

Is the capitalist function distinct from the entrepreneurial function in modern economies? Or does a person have to be wealthy before he or she can start a business? Knight and Schumpeter held different views on the answer to this question. Our empirical findings side with Knight: Liquidity constraints bind, and a would-be entrepreneur must bear most of the risk inherent in his venture. The reasoning is roughly this: The data show that wealthier people are more inclined to become entrepreneurs. In principle, this could be so because the wealthy tend to make better entrepreneurs, but the data reject this explanation. Instead, the data point to liquidity constraints: capital is essential for starting a business, and liquidity constraints tend to exclude those with insufficient funds at their disposal.

Gentry, W.M. and Hubbard, Glenn .R.- (2004) ‘Entrepreneurship and Household Saving’, The B.E. Journal of Economic Analysis & Policy, 4(1), pp. 1–57.

[W]e argue that costly external financing for entrepreneurial investments (coupled with potentially high returns on those investments) has important implications for the saving, investment, and entry decisions of continuing and potential entrepreneurs. These effects are similar in spirit to the role played by costly external financing on investment by corporations. Using data from the 1983 and 1989 Federal Reserve Board Surveys of Consumer Finances, we quantify three findings about entrepreneurial saving decisions and their role in household wealth accumulation. First, entrepreneurial households own a substantial share of household wealth and income, and this share increases throughout the wealth distribution and the income distribution. Second, the portfolios of entrepreneurial households, even wealthy ones, are very undiversified, with the bulk of assets held within active businesses. Third, wealth-income ratios and saving rates are higher for entrepreneurial households even after controlling for age and other demographic variables. Taken together, these findings suggest that studies of household saving decisions in general and of the savings decisions of wealthy or high-income households in particular have paid insufficient attention to the role of entrepreneurial decisions and their role in wealth accumulation.

Hurst, E. and Lusardi, A. (2004) ‘Liquidity Constraints, Household Wealth, and Entrepreneurship’, Journal of Political Economy, 112(2), pp. 319–347.

The propensity to become a business owner is a nonlinear function of wealth. The relationship between wealth and entry into entrepreneurship is essentially flat over the majority of the wealth distribution. It is only at the top of the wealth distribution—after the ninety-fifth percentile—that a positive relationship can be found. Segmenting businesses into industries with high– and low–starting capital requirements, we find no evidence that wealth matters more for businesses requiring higher initial capital. When using inheritances as an instrument for wealth, we find that both past and future inheritances predict current business entry, showing that inheritances capture more than simply liquidity. We further exploit the regional variation in house prices and find that households that lived in regions in which housing prices appreciated strongly were no more likely to start a business than households in other regions.

Hvide, H. K., & Meling, T. G. (2023). Do Temporary Demand Shocks Have Long-Term Effects for Startups?. The Review of Financial Studies, 36(1), 317-350.

Using procurement auctions and register data, we find that temporary demand shocks have long-term effects for startups. Startups that win a procurement auction have 20% higher sales and employment and are more profitable than startups that narrowly lose an auction, even several years after the contract work has ended. There are no such effects for mature firms. The effects for startups are large: about 50% of the contract value is transmitted into long-term sales. Our analysis suggests learning-by-doing as a plausible mechanism. Overall, our results point to the importance of path dependence in shaping the long-term outcomes of startups.

Kerr, W.R. and Nanda, R. (2011) Financing Constraints and Entrepreneurship, Handbook of Research on Innovation and Entrepreneurship. Edward Elgar Publishing.

This article reviews two major streams of work examining the relevance of financing constraints for entrepreneurship. The first research stream considers the impact of financial market development on entrepreneurship. These papers usually employ variations across regions to examine how differences in observable characteristics of financial sectors (e.g., the level of competition among banks, the depth of credit markets) relate to entrepreneurs’ access to finance and realized rates of firm formation. The second stream employs variations across individuals to examine how propensities to start new businesses relate to personal wealth or recent changes therein. The notion behind this second line of research is that an association of individual wealth and propensity for self-employment or firm creation should be observed only if financial constraints for entrepreneurship exist.

Rajan, R.G. (2012) ‘Presidential Address: The Corporation in Finance’, The Journal of Finance, 67(4), pp. 1173–1217.

To produce significant net present value, an entrepreneur has to differentiate her enterprise from the ordinary. To take collaborators with her, she needs to have substantial ownership, and thus financing. But it is hard to raise finance against differentiated assets. So an entrepreneur has to commit to undertake a second transformation, standardization, that will make the human capital in the firm, including her own, replaceable, so that outside financiers obtain control rights that will allow them to be repaid. A vibrant stock market helps the entrepreneur commit to these two transformations. The nature of firms and financing are intimately linked.

Stiglitz, J.E. and Weiss, A. (1981) ‘Credit Rationing in Markets with Imperfect Information’, The American Economic Review, 71(3), pp. 393–410.

[…]The object of this paper is to show that in equilibrium a loan market may be char­acterized by credit rationing. Banks making loans are concerned about the interest rate they receive on the loan, and the riskiness of the loan. However, the interest rate a bank charges may itself affect the riskiness of the pool of loans by either: 1) sorting potential borrowers (the adverse selection effect); or 2) affecting the actions of borrowers (the incen­tive effect). Both effects derive directly from the residual imperfect information which is present in loan markets after banks have evaluated loan applications. When the price (interest rate) affects the nature of the trans­action, it may not also clear the market.

Personal wealth, taxes and employment

Bellon, A., Cookson, J. A., Gilje, E. P., & Heimer, R. Z. (2021). Personal wealth, self-employment, and business ownership. The Review of Financial Studies, 34(8), 3935-3975.

We study the effect of personal wealth on entrepreneurial decisions using data on mineral payments from Texas shale drilling to individuals throughout the United States. Large cash windfalls increase business formation by 0.8 to 2.1 percentage points, but do not affect transitions to self-employment. By contrast, cash windfalls significantly extend self-employment spells, but do not affect the duration of business ownership. Our findings help reconcile contrasting findings in prior work: liquidity constraints have different effects on entrepreneurial activity that may depend on the entrepreneur’s motivations.

Herkenhoff, K., Phillips, G.M. and Cohen-Cole, E. (2021) ‘The impact of consumer credit access on self-employment and entrepreneurship’, Journal of Financial Economics, 141(1), pp. 345–371.

We examine how consumer credit affects entrepreneurship by linking three million earnings and pass-through tax records to credit reports. In the cross-section, we show that self-employment without employees and employer firm ownership increase monotonically with credit limits and credit scores. We then isolate individuals who have had discrete increases in credit limits after the exogenous removal of bankruptcy flags to measure the effects of personal credit on entrepreneurship. Following bankruptcy flag removal, individuals are more likely to start a new employer business and borrow extensively. Those who own businesses with employees borrow $40,000 more after bankruptcy flag removal, a 33% gain relative to the sample average.

Holtz-Eakin, Douglas, David Joulfaian, and Harvey S. Rosen. “Entrepreneurial decisions and liquidity constraints.” The Rand Journal of Economics 25.2 (1994): 334

This paper analyzes the role of liquidity constraints in the formation of new entrepreneurial enterprises. The basic empirical strategy is to determine whether an individual’s wealth affects the probability of becoming an entrepreneur, and the conditional amounts of depreciable assets, ceteris paribus. If so, liquidity constraints are likely to be present. To be successful, such a research strategy requires a measure of asset variation that is both precisely measured and exogenous to the entrepreneurial decision. Our data are uniquely suited for this purpose.  [they have inheritance data from the IRS] Our results suggest that the size of inheritance has a substantial effect on the probability of becoming an entrepreneur, and that conditional on becoming an entrepreneur, the size of the inheritance has a statistically significant and quantitatively important effects on the amount of capital deployed. These findings are consistent with the presence of liquidity constraints.

Hombert, J., Schoar, A., Sraer, D., & Thesmar, D. (2020). Can unemployment insurance spur entrepreneurial activity? Evidence from France. The Journal of Finance, 75(3), 1247-1285.

We evaluate the effect of downside insurance on self-employment. We exploit a large scale reform of French unemployment benefits that insured unemployed workers starting businesses. The reform significantly increased firm creation without decreasing the quality of new entrants. Firms started post-reform were initially smaller, but their employment growth, productivity, and survival rates are similar to those pre-reform. New entrepreneurs’ characteristics and expectations are also similar. Finally, jobs created by new entrants crowd out employment in incumbent firms almost one-for-one, but have a higher productivity than incumbents. These results highlight the benefits of encouraging experimentation by lowering barriers to entry.

Tsoutsoura, M. (2015) ‘The Effect of Succession Taxes on Family Firm Investment: Evidence from a Natural Experiment’, The Journal of Finance, 70(2), pp. 649–688.

This paper provides causal evidence on the impact of succession taxes on firm investment decisions and transfer of control. Using a 2002 policy change in Greece that substantially reduced the tax on intrafamily transfers of businesses, I show that succession taxes lead to a more than 40% decline in investment around family successions, slow sales growth, and a depletion of cash reserves. Furthermore, succession taxes strongly affect the decision to sell or retain the firm within the family. I conclude by discussing implications of my findings for firms in the United States and Europe.