Lecture 6: Entreprenuership

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Lecture 6 Entreprenuership
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Part 1Some Data Sources For Entrepreneurship
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Data for Todays Class

• Distribution of Firms by Size and Age
  (aggregates)
• Statistics of U.S. Businesses (SUSB)
  http//www.sba.gov/advo/research/data.html
• Measures number of employees, number of firms,
  births, deaths, and growth (all in total and by
  firm size) by detailed industries.
• Allows one to compute the distribution of firm
  size over time by industry.
• Large literature trying to explain the size
  distribution of firms.

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Data for Todays Class

• Micro Data on Small Firms
• Survey of Small Business Finances (SSBF)
• http//www.federalreserve.gov/ssbf/
• Conducted by Board of Governors
• 1987, 1993, 1998, and 2003 (repeated cross
  sections)
• Measures detailed descriptive and financial data
  on firms with less than 500 employees
  (non-agricultural)

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Data for Todays Class

• Micro Data on Small Firms
• Kauffman Firm Survey (KFS)
• http//www.kauffman.org/research-and-policy/kauff
  man-firm-survey.aspx
• Conducted by Kauffman Foundation
• 2004 2007 (Longitudinal Survey)
• Measures detailed descriptive and financial data
  on small businesses
• Starts with new businesses in 2004.
• Follows survivors through 2007.

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Data for Todays Class

• Micro Data on Small Firms
• PSID (longitudinal)/CPS (some longitudinal/mostly
  repeated cross sections)
• Collects data on the self employed.
• Collects data on business owners.
• Most micro data empirical work on
  entrepreneurs use household level data where
  entrepreneur is equated with the self employed or
  with small business owners.

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Cool Data that is Underutilized

• Longitudinal Business Database
• From U.S. Census (available for use only at
  Census Research Data Centers (there is one at the
  Chicago Fed).
• Tracks the dynamics of all firms in the U.S.
  (across all industries and all sizes) since 1976
  (including births and deaths).
• Based on tax records.

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Part 2Standard Model Liquidity Constraints
and Small Business Formation
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Why Do People Start Businesses?

• Small Business Skills (Innovators) (Schumpter
  (1934), Evans and Jovanovic (1989))
• Risk Preferences (Kihlstorm and Laffont (1979),
  Jovanovic (1979))
• Jack of All Trades (have better management
  skills) (Lazear (2005))
• Two major questions in the literature
• Why cant innovation take place in the existing
  firms?
• Can the new firms get financing?

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Evans and Jovanovic (1989)
Choice Become a worker Earn wage
(w?) Become an entrepreneur Earn income (
) where ? is entrepreneurial
ability (know when making choice) k is capital
necessary to start a business ? is returns to
scale on capital Note Assume innovations to
w and y are uncorrelated. Assume that ability
(?) is uncorrelated with market wage. Assume
risk neutrality.
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Evans and Jovanovic (1989)
Entrepreneurial Income where z is initial
wealth Constraint Firms can at most borrow
? times their initial wealth to fund their
capital project. Note Borrowing rate lending
rate r (same for everyone).
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Optimal Capital Stock
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Probability of Entrepreneurship Increasing in
Wealth
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Finish Solving The Model
Entrepreneurial Income as a function of
constrained/unconstrained k.
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Compare Entrepreneurial Earnings to Wages
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Evans and Jovanovic Conclusions

• Richer households are less bound by liquidity
  constraints and as a result
• are more likely to enter entrepreneurship.
• Should see a positive relationship between
  initial wealth and entry into
• small business ownership.

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Part 3Testing for the Importance of Liquidity
Constraints
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Old School Tests of Liquidity Constraints for
Entrepreneurs

• Basically, the majority of empirical papers
  regress business ownership (the propensity to
  become a business owner, the propensity to
  survive as a business owner) on household wealth.
• Prob (Start Business (t, t1)) a0 a1
  ln(Wealth(t)) ? X e
• Early research concluded that if wealth is
  significant in predicting business entry,
  liquidity constraints are binding. (i.e., a1 gt
  0)
• Approach taken
• Evans and Jovanovic (1989, JPE)
• Evans and Leighton (1989, AER)
• Fairlie (1999, Journal of Labor Economics)
• Quadrini (1999, Review of Income and Wealth)

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Limitations of Approach

• Is the level of wealth exogenous from other
  factors that cause entrepreneurial entry?
• High ability earn more (accumulate more for
  retirement) and may be better at innovating.
• Risk preferences can cause high wealth and taste
  for entrepreneurship
• People planning for self employment accumulate
  assets for their retirement (do not have
  pensions).
• Try to find an instrument.

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Inheritances as an Instrument

• Instrument for wealth - look at liquidity
  windfalls which are uncorrelated with the
  decision to become an entrepreneur.
• Many use inheritances as instrument.
• Find inheritances are strongly correlated with
  entrepreneurial entry. Receiving an inheritance
  in year t predicts entrepreneurial entry between
  t and tk.
• Holz-Eakin, Joulfaian, and Rosen (JPE, 1994)
• Blanchflower and Oswald (1998, Journal of Labor
  Economics).

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Up Though 2003 Conventional Wisdom

• Liquidity constraints are an important deterrent
  to small business formation.
• Liquidity constraints to small business formation
  is an important explanation of the dispersion in
  wealth (rich people keep accumulating wealth to
  relax their liquidity constraint for their small
  business).
• - Cagetti and DeNardi (2006, JPE).
• Welfare costs of liquidity constraints to
  entrepreneurship is large
• - Buera (2009, Annals of Finance)
• Both papers use as the basis of their models, the
  relationship between wealth and starting a
  business using household micro data.

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A Re-Evaluation of The Facts

• Liquidity Constraints, Household Wealth and
  Entrepreneurship?
• Erik Hurst
• University of Chicago and NBER
• Annamaria Lusardi
• Dartmouth College and NBER

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Goal

• Are people interpreting the data correctly?
• This paper
• I think that the relationship between wealth and
  small business start-up using micro data (or firm
  level data) is not what people think.
• Paper with Ben (coming later)
• In the micro data, do small business match our
  conceptual models of entrepreneurs?
• If not, what can explain the propensity to become
  small business owners in the data?

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Some Facts About Small Business Owners

• How much money do small business owners need to
  start their business?
• 1987 NSSBF Median amount of capital to start a
  business is 22,700
• 25 start with less than 5,000
• 1982 Characteristics of Business Owners (Meyer
  1990) report even smaller figures
• 63 of non minority males and 78 of black
  business owners started with less than 8,700
  (1996 dollars)
• Inc Magazine 500 fastest growing companies in the
  U.S. (Bhidé 2000)
• 26 started with less than 5,000 in upfront
  capital
• Median was not much higher.

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Starting Capital Value Starting Capital Value Starting Capital Value
Industry 1st Quartile Median 3rd Quartile of Firms
Low Starting Capital Industries
Construction 2,860 9,500 30,100 10.9
Services 3,450 19,400 62,719 30.3
High Starting Capital Industries
Mining 1,730 37,800 394,375 1.2
Transportation, Communication and Public Utilities 15,120 47,300 143,300 3.0
Finance, Insurance and Real Estate 7,900 36,500 173,260 4.8
Manufacturing 16,165 47,300 151,200 7.9
Wholesale Trade 11,010 41,400 145,860 8.5
Retail Trade 21,880 55,200 118,150 33.3

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What We Do in this Paper

• Formally Test The Importance of Liquidity
  Constraints and Business Ownership
• Examine the relationship between own wealth and
  business entry
• Examine the relationship between parental wealth
  and business entry
• Look at the wealth/business entry relationship by
  types of business
• Instruments for wealth changes
• Inheritances
• Capital gains on housing.
• Look at survival probabilities

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Data Source

• Panel Study of Income Dynamics (PSID)
• Can follow households in and out of business
  ownership. Business ownership is asked in every
  year. Business wealth (and all other wealth)
  asked every five years starting in 1984.
• Main sample of analysis focuses
• Stacked panel Transition into business
  ownership between 1989 and 1990 and
• Transition into business ownership between
  1994 and 1995
• Focus on Non business owners
• Households aged 22 to 60
• Sample size 7,645 observations (almost 5,000
  distinct households).
• For some analysis, we will only use the
  1989-1990 panel (occupation and industry codes
  are not available beyond 1993). 3,645
  observations.

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Initial Methodology

• Run three different types of regressions
• Prob (Start Business (t, t1)) a0 a1
  Wealth(t) ? X e
• Prob (Start Business (t, t1)) a0 a1
  Wealth(t) a2 Wealth(t)2
• a3 Wealth(t)3 a4 Wealth(t)4
• a5 lnWealth(t)5 ? X e
• Prob (Start Business (t, t1)) a0 a1
  Dummy_Wealth_80-95
• a2 Dummy_Wealth_95 ? X e
• X includes controls for age, education, income,
  family structure, prior employment status, and
  prior business ownership.
• Wealth is defined as the sum of savings and
  checking accounts, bonds, stocks, IRAs, housing
  equity, other real estate, and vehicles, minus
  all debts.

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Importance of Parental Wealth
Variables
Include a full set of income and demographic controls? Yes

Households Own Non-Business Net Worth in 1989 8.78 E-8 (6.98 E-8)

Dummy Husband/Wife Father a Business Owner? 0.049 (0.023)

Dummy Parental Wealth 20th - 40th percentile 0.024 (0.020)
Dummy Parental Wealth 40th - 60th percentile 0.002 (0.018)
Dummy Parental Wealth 60th - 80th percentile 0.021 (0.019)
Dummy Parental Wealth 80th - 90th percentile 0.032 (0.021)
Dummy Parental Wealth 90th - 97th percentile 0.025 (0.024)
Dummy Parental Wealth gt 97th percentile 0.072 (0.039)

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Wealth and Business Start Up by Industry

• Wealth should be more important for starting a
  business with high starting capital requirements.
• You need to be rich to start a car factory.
  However, wealth should not matter much to start a
  house-cleaning business.
• We explore heterogeneity in starting businesses
  of differing starting capital amounts. Perhaps
  the heterogeneity is masking evidence that
  liquidity constraints exist.
• Create Two Categories
• Low Starting Capital (Construction and Services)
• High Starting Capital (FIRE, Manufacturing,
  Transportation, Wholesale and Retail Trade,
  Communications)
• Note PSID has two additional industries Farming
  and Professionals
• We will look at professionals separately

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What about Inheritances as an Instrument?

• Fact is replicated in our data set. Is the
  case closed? No Why?
• Many business are transferred at the time of
  death (5 of NSSBF sample)
• More importantly, inheritances are not randomly
  distributed in the population.
• Those who get inheritances are just different
  (on average) from those who do not.
• A counterfactual
• Test of the latter proposition ?
• Do future inheritances (received after the
  business is started) predict current business
  entry?

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A New Instrument

• We use an alternative measure of liquidity
  Regional variation in housing prices.
• Much evidence that households do borrow against
  home equity to sustain consumption or finance
  investment projects.
• Brady, Canner and Maki (2000) 20 of those who
  removed equity during the late 1990s when
  refinancing used it to fund business investment.
• Hurst and Stafford (2002) find household who
  lost their jobs in the early 1990s used home
  equity to prop up consumption.
• We predict that households who receive increases
  in home equity all else equal should have
  access to more liquidity.
• Are they more likely to start a business? We
  find NO effect of housing capital gains on
  business entry!

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Some Additional Facts about New Business Owners
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Conclusions For Policy Crowds

• Our findings do NOT promote cutting funding to
  the Small Business Administration (SBA). Part of
  the reason why liquidity constraints may not be
  binding is because of SBA policies.
• Existing evidence on the existence of liquidity
  constraints for small businesses not very
  conclusive.
• Why is it the effect is so large for the really
  rich?
• Outstanding Questions
• Are the business owners in typical household or
  business survey important for economic growth?
• Are there existing households who would start a
  profitable business if they had wealth that just
  are not showing up in the data?
• What drives business ownership decisions for
  median household?

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Part 5The Non-Pecuniary Benefits of
Entrepreneurship
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Some Interesting Facts

• Does the data on small business owners match the
  concept of entrepreneurship in our model?

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Two Additional Results of

• Moskowitz and Vissing Jorgensen (AER 2002)
• Private Equity Puzzle.Measured risk adjusted
  return to public equity is much higher than the
  measured risk adjusted return to private equity.
• Hamilton (JPE 2000)
• Wages of individuals fall sharply (30 at
  median) when household transition into small
  business ownership from wage workers.
• Potential explanation There are non-pecuniary
  benefits to small business formation.
• Consistent with micro data that most small firms
  never grow, never innovation and are concentrated
  in a few industries.