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.

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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.

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Understanding Determinants of Occupational Choice: Wealth or Talent?

Entrepreneurship and Financial Intermediation: Matching Evidence from Credit Contracts