Enterprise Initiative | A Project of the University of Chicago

Understanding Determinants of Occupational Choice: Wealth or Talent?

admin — Fri, 28 Aug 2009 19:58:50 GMT

Thailand provides a unique backdrop in which to examine connections between growth and income inequality. Data show that as the Thai economy grew rapidly between 1976 and 1996, inequality increased and then decreased. Research indicates that a substantial portion of this trend of changing inequality is explained by population shifts across occupational subgroups and associated changes in income gaps; for example, business is a high yield occupation while subsistence earning is a comparatively low yield occupation. Population shifts across sectors are considered to be the driving force of the relationship between growth and income inequality, so it is important to understand how individuals choose their occupations.

In order to learn more about self-selection, Jeong and Townsend (2005) utilize the theoretical framework of occupational choice proposed by Lloyd-Ellis and Bernhardt (2000). At the micro level, we may imagine an economy comprised of subsistence earners, wage earners, and entrepreneurs. Do individuals choose their occupation randomly? Does an individual's initial wealth influence his occupational choice? For instance, we might expect a wealthy individual to start a business, while a poor individual may choose subsistence work or wage labor. In the absence of access to -- and use of -- financial institutions, this theory may be effective in predicting occupational choice. In this discussion, we examine what factors lead individuals to choose their respective occupations.

The Lloyd-Ellis and Bernhardt (LEB) model proposes that each individual is endowed with a certain level of "talent", manifest in the ability to lower the fixed costs of running a business. Ideally, all individuals possessing a high level of talent would want to start a business in order to maximize profits. However, to do so, such talented entrepreneurs most often face an initial cost or investment. Similar financial demands are present for existing entrepreneurs; a talented entrepreneur who has the potential to earn higher returns by expanding his business will likely face costs or investment associated with such an expansion.

In both starting and expanding a business, individuals will remain inefficient if they lack access to finance. In the instance of starting a business, a talented, would-be entrepreneur who lacks adequate capital or credit must instead choose between wage work and subsistence farming, despite his ability to earn more if he could run his own business. Similarly, in the absence of a credit market, a talented entrepreneur is unable to scale his business correspondent to his talent and thus earns below his potential.

Less talented entrepreneurs who have financial means may be able to start and expand a business. However, it is quite plausible that in this instance an individual may actually enjoy higher returns by saving the money in the bank and earning interest, given his low level of talent. In the absence of a financial system that facilitates savings, scaling up actually causes this individual to earn less than what he could have had he been able to combine the profits of his business and the interest earned from savings.

These scenarios illustrate that in the absence of a credit sector, or financial intermediation[1], a disparity between talent and occupation exists. Thus, in the absence of financial intermediation, initial wealth, not talent, becomes a significant determinant of occupational choice. As a result, low wealth renders a talented individual unable to start a business and a talented entrepreneur unable to run his business at an efficient scale.

From this work, we draw the lesson that savings and wealth accumulation, as well as improved financial intermediation, are strategies that can overcome credit constraints in the long run. These strategies can reduce inefficiency in the economy, allowing individual characteristics to drive occupational choice, rather than initial wealth.

To read more about occupational choice, visit Cambridge Journals for an abstract and full PDF version for subscribers.

[1] Financial intermediation constitutes all the activities linking borrowers and lenders. It is often measured by the amount of the intermediated credit or by the number of people who use credit services.

Photo by Gusjer.

Does the Free Market Corrode Moral Character?

admin — Fri, 14 Aug 2009 14:18:08 GMT

Given events in the U.S. economy and around the world over the past year, we thought it might be appropriate to feature a related discussion. The Becker-Posner Blog offers a unique commentary on the free market and its potential impact on the morality of businessmen. University of Chicago economist Gary Becker speaks to several topics of interest to the Initiative in this discussion, including characteristics of free competition, the desire for profit maximization, and the effectiveness of regulatory interventions.

Does the Free Market Corrode Moral Character?
Gary Becker, November 2008

The title of this discussion is taken from a question put by the John Templeton Foundation to leading scientists, scholars, and public figures. The foundation published some of the answers in the New York Times on October19th. It is obvious from the revelations during this financial crisis, the Enron scandal, and other business scandals, that dishonest and morally corrupt figures sometimes are among the leaders in highly competitive industries. Hollywood has often highlighted these figures, such as the morally bankrupt Gordon Gekko in Oliver Stone's film "Wall Street", which probably contributed to the general perception of businessmen as corrupt. Moreover, polls in the United States and Europe usually find that businessmen get a low rating when people are asked about whether they respect them, or believe they are honest, although congressmen in recent polls get an even lower rating than businessmen.

If the question had been put to me, I would have first discussed whether corrupt and dishonest businessmen make greater profits than honest and morally admirable businessmen. Honest businessman would be more successful than corrupt ones when they compete against each other in a free market, as long as consumers can punish dishonest businessmen by not giving them repeat business, (when repeat business is necessary to succeed). Dishonest businessmen may make greater profits in the short run, but honest businessmen make higher profits in the longer run because cheaters cannot attract back customers who they cheated.

Two conditions must be operative for this process to be effective:1) customers must be able to detect when they are being cheated or misled, and 2) customers must be frequent enough buyers, so that repeat business is an important determinant of profitability. Both these conditions often prevail, but one or the other may be absent under certain circumstances. For example, repeat business is not so important in vacation areas where tourists seldom come back. Then morally corrupt and dishonest businessmen may do relatively well, although tourists do get recommendations from friends who have been there before, or from the hotels where they stay. Another example deals with certain durable consumer goods since consumers only infrequently purchase expensive goods like a car or home. Although repeat business is less important in these markets, consumers will put more time and research into considering decisions that require large expenditures. In addition, word of mouth information about the reputations of different sellers can hurt the dishonest sellers.

Even when repeat business is important, consumers would not be able to punish corrupt businessmen if they cannot readily determine whether or not they have been cheated or badly misled. For example, consumers who buy defective used cars that break down only after a year or so of driving may blame the breakdowns on their own actions rather than on the quality of the cars that were sold to them.

Adam Smith claimed that businessmen were, on the whole, more trustworthy than diplomats. His argument was based on the importance of repeated interactions. Essentially, Smith argued that repeat business was usually more important to businessmen than to diplomats. Smith argued that diplomats frequently broke treaties since treaties are made infrequently. As a result, the gain from breaking treaties often exceeds the gain from living up to the obligations imposed by the treaties.

Another, much more famous, result of Adam Smith shows that under certain conditions, businessmen in competitive industries would promote the general welfare, even though they were only trying to increase their profits. These conditions include that businessmen are prevented from colluding-Smith correctly argued that businessmen try to collude in order to exercise monopoly power- and Smith assumed consumers could punish dishonest businessmen.

Many critics judge the performance of free markets relative to alternatives the way a judge might make her decision about the winner of a beauty contest between two contestants. She chose the second contestant after seeing the warts on the first one. Prominent and not so prominent businessmen in market economies have been involved in various scandals where they have provided misleading information, lie, sell shoddy and dangerous products, and the like. When such scandals arise, there is a clamor for greater regulation in the sectors where the scandals occurred, and sometimes even for government takeovers of these enterprises. This presumes that regulators and government officials act with sufficient knowledge about the industries involved, and with great wisdom and morality. Unfortunately, often that is not the case.

Aside from the not infrequent cases of outright bribery of regulators and legislators, many other more subtle ways exist to bias, even corrupt, officials when their decisions replace the forces of market competition. Regulators often get "captured" by the companies they regulate, so that regulations are developed to keep out competition rather than promote greater honest competition (this capture theory was given an economic interpretation by our late friend, colleague, and Nobel-prize winning economist, George Stigler). One of the more notorious examples is the former Civil Aeronautics Board that was supposed to regulate competition among airlines, but had trouble giving approval to new airlines to compete against the established airlines.

Legislators sometimes bail out companies in financial distress, or restrict competition from abroad in order to raise the profitability of domestic companies-in effect they become tools of these companies at the expense of taxpayers and consumers. Why should American automakers get subsidies from the government during this present crisis, and in the past, when they have repeatedly made bad production, marketing, and labor contract decisions during the past 30 years? A free market in the automobile industry with less government involvement would have given American consumers faster and easier access to the cheaper and better cars made by Japanese, German, and now Korean companies.

I might add in concluding that I have spent my whole career in academia, and I have witnessed many examples of morally corrupt behavior by professors. So it is far from obvious to me that businessmen have worse morality than professors, although I may be making the same mistake in this inference as the judge did in the beauty contest I referred to earlier who had seen up close only some of the contestants.

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Photo by Emilio Labrador.

Entrepreneurship and Financial Intermediation: Matching Evidence from Credit Contracts

admin — Mon, 03 Aug 2009 19:54:09 GMT

Wealth creation is closely related to the ability of individuals and households to transform their talent and other inputs into marketable goods and services. The credit market permits the allocation of resources among financial intermediaries such as banks, and talented entrepreneurs, enabling these individuals to start their own businesses and expand their production capacities. This dimension of wealth creation and entrepreneurial dynamism can be uniquely observed in the elements behind a credit contracts, or lending agreements between a bank and an individual. In order to examine the incentives of both banks and entrepreneurs behind these contracts, we take advantage of a unique series of databases that combine quarterly information of banks, firms, and credit contracts for Mexican commercial banking from 2004 to 2007.

The credit contracts we observe differ in terms of interest rates and loan amounts according to the characteristics of both banks and entrepreneurs. For example, firms are characterized by their scale of production, productivity, geographic location, economic sector, and number of workers. On the other hand, intermediaries such as commercial banks, have different managerial capacities and market deepening, traduced in differences among their capitalization costs. Given these characteristics, both groups seek the best loan terms for themselves. Consideration is also given to other factors, such as competitors in the market and conditions of other relevant markets. Therefore, groups on both sides of the market have incentives to "match" with each other and agree to a mutually beneficial contract. As such, banks have developed technology to better seek out talented entrepreneurs*. However, banks may not always make loans to the best customers and the best customers may not always attain the best credit because this optimal matching process can be distorted by the presence of barriers to entry in the industry, fixed costs, asymmetric information, and default incentives, among others.

Using a matching framework adapted to the particularities of bank-client relationships, preliminary analysis finds that talented entrepreneurs are typically offered credit contracts with better terms, such as lower interest rates or higher loan amounts. While this increases investment in an individual's business, it also benefits other entrepreneurs, in that banks seek out talented entrepreneurs, enter into successful credit contracts, and use the profits to extend loans to additional, albeit less talented, individuals. This expansion of credit is fueled further by an increase of banks in Mexico over the time period studied, resulting in outreach of banking credit toward more firms and with lower capital requirements. This acts as trickle-down effect, in that the credit market allocates capital to entrepreneurs via unique credit contracts and facilitates the expansion of the market to additional entrepreneurs.

The process of wealth creation is complex, as we find in this examination of credit contracts and matching. Ultimately, the most talented entrepreneurs are rewarded with better loan terms. Others, too, benefit from this process, as credit is extended to more individuals. The credit market's role in entrepreneurial success should not be understated, as it enables - or prevents - individuals from starting businesses, purchasing necessary assets, and expanding production.

Post submitted by Jorge O. Moreno, Ph.D. Candidate at the University of Chicago

*Entrepreneurial talent is defined by productivity.

Photo by malias.

What Makes an Entrepreneur Successful?

admin — Wed, 22 Jul 2009 14:38:10 GMT

What distinguishes entrepreneurial individuals from others? How do some of a society's poorest individuals manage to succeed? What strategies do they use? What constitutes this spirit of wealth creation?

These questions represent the essence of our research. One thought is that luck alone explains the success of an entrepreneur. Luck, by definition, is a random phenomenon - it can come and go without notice. If luck determined success, we would not expect a pattern of outcomes, and success in one period would have no correlation with success in a subsequent period. Naturally, this would make a policy discussion difficult since there are no practical means by which we can control or influence luck.

By studying the Townsend Thai Survey data, a monthly panel of data that follows several hundred households in Thailand for nearly a decade, we can reasonably rule out luck as a significant factor in determining success. Research indicates that instead of luck, other factors are associated with success*. In particular, we find that something specific to each household contributes largely to success. This brings us closer to visualizing what factors can make an individual successful.

What specific attributes contribute to success?

The Townsend Thai monthly data allow us to observe across time and identify which households are successful and which households are not. Success cannot simply be attributed to the age of the household head, his or her level of education, or the number of household members. In addition to these, analysis indicates that specific factors unique to each household also contribute to success. For one household this factor could be the members' motivation to select better inputs for its business, while for another household it could be the ability to share knowledge and expertise among members effectively.

The data provide an in-depth look, but looking at households all together does not allow us to tease out what these household specific factors are. By constructing household case studies and through supplemental field visits and interviews, researchers have been able to gain a better understanding of what such factors might be. In one instance, our researchers visited a successful household that relied upon dairy farming as its main source of income. The entrepreneurial motivation of the household members was evident as they explained what set them apart from other households engaged in the same occupation. Both adult members of the household attributed their attention to cow selection as a significant factor in their success. They actively consulted cow merchants to learn how to select healthy cows and subsequently used these tips to acquire healthy animals. Additionally, when one member received training on dairy farming, the member's spouse also invested time in learning those skills from her. Thus, we observe an entrepreneurial motivation, paired with skill building, specific to this household that drives its outcome.

Does this success last?

We return to our initial question: what makes an entrepreneur successful? In studying this large range of data we are able to identify strong patterns of success among households, in that households that were successful in one period were far more likely to be successful again in the future. This high level of persistence confirms that luck does not play a significant role in determining success. Rather, we find that household-specific factors, such as entrepreneurial motivation or initiative to seek out and share expertise, contribute most notably to entrepreneurial success. Research continues to further investigate the determinants of success in order to better answer these compelling questions of successful enterprise and wealth creation.

To read more about factors that contribute to entrepreneurial success, visit http://townsend.uchicago.edu/Wealth%20Accumulation_June%202009.pdf.

*Success can have many different interpretations. As an indicator for success, we use the return on assets (ROA), or how much profit a household can generate given a certain amount of assets. A high ROA number corresponds to a high level of success.

Photo by flickr user bfick.

From Economies to Models and Back Again

admin — Fri, 26 Jun 2009 20:57:51 GMT

Complete "realism" is clearly unattainable, and the question whether a theory is realistic "enough" can be settled only by seeing whether it yields predictions that are good enough for the purpose in hand or that are better than predictions from alternative theories. Yet the belief that a theory can be tested by the realism of its assumptions independently of the accuracy of its predictions is widespread and the source of much of the perennial criticism of economic theory as unrealistic.

-Milton Friedman, The Methodology of Positive Economics, 1953.

My friends with engineering and natural science background often fall into a state of cognitive dissonance when I try to explain to them how models in economics actually work and why very profound and useful results can be obtained from models with conditions that seem to be counter-intuitive, esoteric and "not realistic". Why subjective future discount factor is set at magical number of 0.96? Why would venture capital and private equity managers typically get 20% share of enterprise profit or more but never less nor matter how bad the state of economy is? Why an advanced model with limited number of highly simplified agents and production sectors but with private information and capital misallocations actually works well while complex multi-sector model with detailed inputs for each factor of production done in standard CGE framework according to the best mathematical and computational recipes fails miserably to describe even the simplest price and output dynamics anywhere but the most trivial cases?

At some level general equilibrium theory is vacuous. For example, for pure exchange economies it is known that one can generate any aggregate excess demand function by a suitable specification of endowments and preferences. Related, unobserved shocks to preferences with arbitrary probability distributions can generate arbitrary patterns of cross household consumptions. So, if some version of an enlarged model always fits, to what extent does general equilibrium theory have content?

...

Again, general equilibrium models allow one to think logically about the implications of some premise, to trace out the implications of the premise not only for the phenomenon of interest but for other phenomena as well. That is, one can keep track of all possible interactions across agents in the economy, showing some phenomena to be logically inconsistent with other phenomena.

-Robert M. Townsend,"Models as Economies" in The Economic Journal, 98 (1987).

Try to imagine the physical world in which gravitational "constant" is no longer constant but changes from place to place and unexpectedly in time. It would take quite a leap of imagination to discover a "true" law of motion in such world when so much visible complexity is lying on the surface and so many alternative versions would fit "reality" equally well. And that's precisely the word where economics models apply. It is really amazing that there exist forms of economic activity including their quantitative characteristics (such as ex-ante division of profits in entrepreneurial contracts) that can be observed and traced through hundreds of years in human history. To find such economic patterns and more importantly the dynamics of change in those patterns both spatially and across time you need to go into a fairy land of economic modeling with strict logical, quantitative, computational discipline enforced and come back again to a subset of actual economies and data in which relevant phenomena manifest themselves most clearly. This journey of course is fraught with many obstacles and perils but that's what any good journeys is ultimately about.

Post submitted by Victor Zhorin, University of Chicago Computation Institute

Does Enterprise Really Create Growth?

admin — Fri, 21 Nov 2008 20:24:13 GMT

Entrepreneurs are considered a source of innovative ideas, unique perspectives and much-needed enterprise, but their role in a developing country is even more critical. The entrepreneur drives both growth and productivity.

A close examination of financial access is essential to this discussion, as financial liberalization is a driving force behind productivity growth in developing countries. Typically, access to financial systems increases over time; in Thailand, we see growth from 6% of the population to 26% over the years between 1976 and 1996. Such access results in better allocation of capital, labor and talent – and increases in efficiency.

To better understand the necessity of financial access and the sources of inefficiencies in developing countries, think of a poor, but talented household with no access to credit. Although the household could set up a business, it is likely destined to remain relatively unproductive because of the constrained scale on which it must run. Likewise, we find inefficiencies at another household in the same village. This household, a wealthy but rather untalented group, puts its wealth into a business for lack of better, interest-bearing savings options. We find that a similar problem ensues – the household’s lack of talent translates into an unproductive enterprise.

Consider a scenario where enterprise is supported by access to savings and borrowing mechanisms. The talented, poor household can receive a loan and operate its business on a larger, more efficient scale. The wealthy but not-so-talented household will abandon enterprise in favor of savings as its wealth is put to better use. When the ability to borrow from a bank is introduced in a developing economy, the result is better allocation of talent, greater profits, increases in wealth and improvements in efficiencies.

Enterprise continues to play a role as an economy grows and matures. Talented workers leave jobs as unskilled workers, instead devoting time to entrepreneurship. The demand for labor increases with enterprise formation, consequently boosting wages. Furthermore, enterprise pursuits increase capital so interest rates fall. Each, in turn, contributes to growth and productivity.

Ultimately, entrepreneurship can be used as a tool in addressing poverty in developing countries. Its ability to open new possibilities for others and create wealth is instrumental in creating economic growth and improving productivity.

For Townsend and Jeong's full text article, please visit http://cier.uchicago.edu/papers/Jeong/TFPjtETSpecial.pdf.