entrepreneurship, business wealth, and social...

Entrepreneurship, Business Wealth,

and Social Mobility

Gabriel Basaluzzo

UT Austin/ITAM Exchange ConferencePreliminary

November 17th 2006

Gabriel Basaluzzo Entrepreneurship, Business Wealth, and Social Mobility

IntroductionWealth ConcentrationEntrepreneurship and wealthGoals

Wolff (1995) documented two main facts (and a puzzle):1 Wealth and income are heavily concentrated in U.S.2 Wealth is more concentrated than income3 Gini coefficients: 0.54 (income) vs. 0.86 (wealth)4 Top 1% holds 36% of total net worth, 17% of total income

Standard models based on precautionary savings failed toaccount for such concentration.Aiyagari (1994), Hugget(1996), Hubbard,Skinner & Zeldes (2004), De Nardi

(2004)

Entrepreneurship and wealth

Using SCF data, Quadrini (1999) and Gentry and Hubbard(2004) establish a link with entrepreneurial activities.

1 Entrepreneurs present similar pattern to that in Wolff.( 10% of households, hold 22% of income and 40% of wealth)

2 They are more prevalent among the rich.(65% in richest 1%, 42% among the top 10%)

Major role played by the value of own business in portfoliocomposition and social mobility of entrepreneurs

1 Richest 1% business owners: 80% of net worth– Carroll (1994), 50% for the median entrepreneur –

2 Cause for abrupt changes in net worth of entrants (40%) andexiting (-60%) entrepreneurs

3 Accounts for the three times larger W/Y ratio observed in thedata for entrepreneurs vs workers

Accounting for the wealth of Entrepreneurs

Quadrini (1999) and Cagetti and DeNardi (2006): models ofentrepreneurship with borrowing constraints

1 Match wealth concentration for income and wealth2 Rely on high returns to saving, and precautionary motives3 Businesses have no intrinsic value

Why do the models work: Calibration1 Overestimate the profitability of ventures2 Underestimate borrowing constraints

Why caring about business wealth and calibration?1 Explain level and changes in portfolio composition of the rich2 Dynamics of wealth over the life cycle, entry and exit3 Welfare effects of borrowing constraints

Contribution of the paper

Incorporate business wealth into models of entrepreneurialchoice

Reservation price

(For now) Calibrate it the usual way

See how much does business wealth changes:

Dynamics of wealth and portfolio composition of entrepreneursMeasures of inequalityAssessment of borrowing constraints

Study the room for a market for businesses

Reservation price

The ModelHouseholds & FirmsMarkets & InstitutionsHousehold problem & Equilibrium

Household Characteristics

Continuum of measure one

Infinitely lived, with preferences

∞∑

βt u (ct)

Characterized by three variables (ε, η, a)

Quality of business idea ε ∈ E . Non-transferable. MarkovTransition Φd ′

(ε′; ε), d ′: next period occupation

Efficiency units of labor η ∈ H. Markov with Γ (η′; η)

ε and η observable. Updated when a period begins.

Liquid assets a.

Production Sector

Entrepreneurial Firms

y = εf (k, n + η)

k : working capital, n : additional laborTypically f (.) =

kα l1−α)

ν, 0 < ν < 1, l = n + η

Corporate SectorLarge firms. Easy access to capitalCRS → aggregation into a single firm

Y = F (K ,L)

Capital in all sectors depreciates after production at rate δ

Production Sector

Entrepreneurial Firms

y = εf (k, n + η)

k : working capital, n : additional laborTypically f (.) =

kα l1−α)

ν, 0 < ν < 1, l = n + η

Corporate SectorLarge firms. Easy access to capitalCRS → aggregation into a single firm

Y = F (K ,L)

Capital in all sectors depreciates after production at rate δ

Labor and Capital Markets

Labor market

Occup. choice

d′ ∈ {0, 1}

(ε, η, a)

(ε′, η′)

Labor is

PRODUCTION

Labor payment

w η′

CONSUMPTION c

SAVING a′

Occup. choice

Capital Market

Financial Intermediary / Bank → Short term loans

Collects deposits

Lends to firms

PRODUCTION

Collects

(1 + i)k

(1 + i)a

CONSUMPTION c

SAVING a′

Collects deposits

Borrowing Constraints

Entrepreneurs have limited commitment

Imperfect enforceability of contracts

Default does not carry consequences over time

Bank can seize (1 + i) a + γ (εf (k, n + η) − wn)

Entrepreneurs do not default if

(1 − γ) [ε f (k, n + η) − wn] + k (1 − δ) ≤

≤ ε f (k, n + η) − wn − (i + δ) k + (1 + i) a

Borrowing Constraint

b = a +γ

(1 + i)[ε f (b, n (ε, η, b) + η) − w n (ε, η, b)]

Corporate Sector has commitment

Household problem in recursive form

End of period: Individual state is z2 = (ε, η, d , a′)

= β maxd ′∈{0,1}

z1′)

η′|η)

Φd ′ (

ε′|ε)

with z1′ = (ε′, η′, d ′, a′).

Household problem in recursive form (cont.)

Beginning of a period, z1 = (ε, η, d , a)

= maxc,a′≥0 u (c) + v2(

subject to

a′ + c ≤ y(

+ wη + (1 + i) a

ε, η, d , a′)

0 if d = 0π (ε, η, a) if d = 1

π (ε, η, a) = max0≤ k ≤b(ε,η,a)0≤n

ε f (k, n + η) − w (n + η) − (δ + i) k

Household wealth

Businesses are valued at the end of a period: q(ε, η, d , a′)

q(ε, η, d , a′) is computed as a reservation price

q (ε, η, a′, d) = minx≥0 x

s.t. v2 (ε1, η, d , a′ + x) − v2 (ε, η, d , a′) ≥ 0

Wealth = a +q(ε, η, d , a′)

If the household is a worker,d = 0, wealth = a

Steady state recursive competitive equilibrium

Characterized by value functions v1 (.), v2 (.) , policies c (.),a (.), k (.), n (.), d (.), prices i ,w , input demand functionsLc (w , i) ,Kc (w , i), and a measure µ such that

Value functions and decision rules are solutions to thehouseholds’ and firms’ programming problems.

Prices {i , w} are competitive.

Capital and labor markets clear

Measure µ is stationary and the transitional operator T (.)mapping µ′ = T (µ) is consistent with individual behavior

Parametrization Generalities

Strategy

There are two ways to proceed:

Ignore q in the calibration and see later how its inclusionaffects the resultsAdd q to the calibration and see later how its exclusion affectsthe results

First approach: allows comparison with existing results

Follow Quadrini (2000), Cagetti and DeNardi(2006) andVillaverde(2003).

E = {ε1, ε2, ε3, ε4}. ε1 = 0, ε2 = 1,ε3 = 1.26 and ε4 = 1.68.

Strategy

E = {ε1, ε2, ε3, ε4}. ε1 = 0, ε2 = 1,ε3 = 1.26 and ε4 = 1.68.

Strategy

E = {ε1, ε2, ε3, ε4}. ε1 = 0, ε2 = 1,ε3 = 1.26 and ε4 = 1.68.

ResultsBusiness wealthWealth InequalityMarket for Businesses

Business Wealth Determination

0.0001 0.001 0.01 0.1 1 10 100 1000

liquid assets

0.0001 0.001 0.01 0.1 1 10 100 1000

liquid assets

0 50 100 150 200 250 300

Liquid assets

Portfolio Composition of Entrepreneurs

At the average asset holdings of a worker 2.6, with w = 0.8 and η2 = 0.93, thevalues of businesses are 0.95, 9.14 and 14.34.

All entrep ε2 ε3 ε4 AllShare of Population 0.099 0.069 0.028 0.01 1Share of all assets held 0.41 0.123 0.187 0.103 1Share of all wealth held 0.53 0.112 0.261 0.162 1Portfolio share in business 0.39 0.137 0.434 0.500Mean assets holdings (workers) 2.56Mean assets holdings (entrep) 16.33

Table: Composition of the entrepreneurial sector

Wealth Dynamics

Simulation of 20,000 households

Randomly started. Initialization window: 5,000 periods

Information recorded at T=0 and T=5

Results similar to Gentry and Hubbard (2004)

60% of wealth changes are related to business value

Staying Entrepreneur 6.97 8.22 1.29 0.24 0.22Switching Worker 2.13 3.00 1.48 0.87 0.33

Switching Entrepreneur 4.34 3.93 -1.96 -0.46 -0.20Staying Worker 1.36 1.35 -0.05 -0.02 -0.02

Table: Dynamics of wealth

Impact on wealth inequality

0 0.2 0.4 0.6 0.8 1

share of agents

Gini coefficient increases from 0.83 to 0.85

Total wealth increases by 26%

Concentrated in the hands of 4% of households

γ must increase from 0.6 to 1.4 to match the new Gini

A Market for Businesses?

Buying (red) / Selling (blue) prices. Businesses of type ε2

No trade region No buyers

Trade region

Buying (red) / Selling (blue) prices. Business of type ε4

No trade region No buyers

No trade region No sellers

Trade region

Business wealth is an asking price

Bidding price:

(ε, η, a′, d) = max0≤x≤a′ x

s.t. v2`

εj , η, d, a′ − x´

− v2 (ε, η, d, a′) ≥ 0

There is room for trade. Gains from trade help reduce borrowing constraints.Depends on market characteristics

Conclusions

Conclusions and directions for further research

Adding business wealth to entrepreneurial net worth better accounts for theportfolio composition and wealth dynamics of business owners

Shows that current calibrations underestimate the importance of borrowingconstraints by a large margin

It appears that a market for businesses would be effective in mitigatingborrowing constraints

For further research

Recalibration of entrepreneurial sectorLife cycle model of self made rich

Model of business transfers: lock-in effects, market frictions and welfare

Conclusions

Conclusions and directions for further research

Adding business wealth to entrepreneurial net worth better accounts for theportfolio composition and wealth dynamics of business owners

Shows that current calibrations underestimate the importance of borrowingconstraints by a large margin

It appears that a market for businesses would be effective in mitigatingborrowing constraints

For further research

Recalibration of entrepreneurial sectorLife cycle model of self made rich

Model of business transfers: lock-in effects, market frictions and welfare

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