Information Frictions and Entrepreneurship

Why do individuals become entrepreneurs? When do they succeed? We develop a model in which individuals use pedigree (e.g., educational qualifications) as a signal to convince employers of their unobserved ability. However, this signal is imperfect, and individuals who correctly believe their ability is greater than their pedigree conveys to employers, choose entrepreneurship. Since ability, not pedigree, matters for productivity, entrepreneurs earn more than employees of the same pedigree. Our empirical analysis of two separate nationally representative longitudinal samples of individuals residing in the US and the UK supports the model’s predictions that (A) Entrepreneurs have higher ability than employees of the same pedigree, (B) Employees have better pedigree than entrepreneurs of the same ability, and (C) Entrepreneurs earn more, on average, than employees of the same pedigree, and their earnings display higher variance. We discuss the implications of our findings for entrepreneurship, education, and public policy.