Student Research

What Makes the Decision to Become an Entrepreneur Rational?

By Sarada

[Photo: Sarada]

Sarada is currently a fifth-year Ph.D. candidate in the Department of Economics.

Why should we care about entrepreneurship?

Policy makers in recent years have designated substantial resources for the promotion of entrepreneurial activity, particularly in small-business formation. Entrepreneurial activity is believed to create wealth, employment, and innovation that spurs economic growth. It enables the realization of unprecedented ideas, which in turn drives technological change and furthers economic growth.

Entrepreneurs assume the role of risk-bearing agents. They are willing to sacrifice the certainty of wage employment and instead take a chance in implementing new ideas in the hope of reaping high returns. This internalization of risk on the part of the entrepreneur can provide many positive externalities once favorable returns are realized. There is little disagreement, if any, on the benefits of “good” entrepreneurial activity, yet it is not clear that we have a sufficiently sophisticated understanding of what types of individual and venture characteristics lead to “good” outcomes. It is therefore of great interest to both economists and policy makers to understand who becomes an entrepreneur and how he or she decides to do so.

My research is concerned with trying to better understand the characteristics of entrepreneurs and the reasons they enter into entrepreneurship in order to identify attributes that result in successful outcomes.

The empirical puzzle

My current research is primarily motivated by the intriguing observation that the self-employed (whom I refer to as entrepreneurs for the purposes of my work) earn significantly less than the wage-employed. Specifically, Barton Hamilton, the Robert Brooking Smith Distinguished Professor of Entrepeneurship, finds that the median individual in self-employment can expect to earn about 35 percent less than his or her contemporaries in wage employment. This curious observation leads to the obvious question: What factors, if not financial returns, motivate individuals to switch to self-employment?

My work, supervised by Professor Roger Gordon, attempts to rationalize this observation by proposing and testing various hypotheses, new and old. I have received generous support from the Kauffman Foundation for this work through a 2010 Kauffman Dissertation Fellowship.

A couple of fairly intuitive explanations for this observation are, first, that individuals get nonincome returns from being self-employed. For example, people may be willing to incur a significant pay cut to be their own boss. Second, it is feasible that individuals overestimate the returns from owning their own business and therefore enter into self-employment as a result of (misguided?) expectations. Both of these explanations, while intuitive, are not immediately testable since neither factor has a straightforward observable measure. In my work, I propose possible mechanisms to estimate these factors. Furthermore, I go beyond the explanations outlined above (which prevail in the existing research) by proposing and testing a few alternative hypotheses that would also lead to the puzzling observation that individuals in self-employment earn significantly less.

I make a case for the possibility of income underreporting by looking at the discrepancy between reported income and consumption, and how this differs between the wage-employed and the self-employed. Individuals who own their own businesses have far more discretion in deciding where and how to declare earned income. As such, comparing reported income alone across employment types might not be the best way to make comparisons.

I also distinguish between individuals who move into self-employment from wage-employment voluntarily versus involuntarily (i.e., quit versus fired). It is clear that the incentives faced by the former differ significantly from those of the latter.

Lastly, I evaluate the possibility that the financial returns to wage-employment and self-employment differ in the amount of time invested. For example, total returns to wage-employment tend to simply be the product of the wage rate and the number of hours worked; however, this is not necessarily the case when working for oneself. It is possible to imagine that business owners get incrementally higher gains with every hour they input. Therefore, a simple one-to-one comparison of wage rates between employment types may not be representative of the true returns to either form of employment.

My work (currently in progress) individually tests each of the hypotheses outlined above. (To get the full findings, contact me in six months.) In addition to understanding entrepreneurial choice and success, I also have a keen interest in understanding different forms of governance and institutions, and the role they play in determining economic development.

Experience at UC San Diego

In my five years here at UCSD, I have developed many intellectual and personal relationships with both colleagues and faculty members. The open and warm environment fostered by the Department of Economics facilitates unprecedented levels of faculty-student interactions.

My colleagues, particularly those in my cohort, have also been a tremendous source of intellectual support. In my batch alone, we have representation from more than twelve countries, and all continents are represented in the department. My colleagues are also from a variety of academic backgrounds, ranging from political science and linguistics to computer science and theoretical physics. Because of the diversity of cultures and skills, I have access to a vast array of thoughts and opinions on practically any issue of interest to me.

On the whole, the UCSD Department of Economics has provided a fertile ground for both my personal and intellectual development.