This paper examines the effects of financial constraints and idiosyncratic risks in a dynamic equilibrium model of occupational choice. We determine the qualitative and quantitative response of aggregate macroeconomic activity, social mobility, and the wealth distribution to credit market improvements.
Our analysis contributes to recent literature on dynamic stochastic heterogeneous agent general equilibrium models concerned with risk and distributional dynamics, for instance Quadrini (2000), Meh (2005, 2008), Bohá?cek (2006, 2007) and Cagetti and De Nardi (2006a,b,c). All these contributions share as common feature that including entrepreneurship and occupational choice into a Huggett (1993) / Aiyagari (1994)–type economy provides a much better explanation of the empirically observed wealth inequality, especially in the upper tail of the distribution. The implications of our model regarding wealth inequality are in accordance with this strand of literature, although our focus is more directed towards the general effects of financial constraints and the question of how sensitive the macroeconomy as a whole responds to a reduction in credit market imperfections.
To this end we develop a model which is more closely related to modern growth theory. Regarding the role of entrepreneurship, we assume a more sophisticated sectoral structure than e.g. Bohácek (2006) or Cagetti and De Nardi (2006a). We combine occupational choice under risk à la Kihlstrom and Laffont (1979) and Kanbur (1979a,b) with the two–sector approach of Romer (1990), but without endogenous growth. In each period of time, the risk–averse agents choose between between two alternative occupations.
They either set up an enterprise in the intermediate goods industry which is characterized by monopolistic competition. Or, they supply their labor endowment to the production of a final good in a perfectly competitive market. Producers of the final good use capital and labor inputs, and differentiated varieties of the intermediate good. All households are subject to an income risk. Managerial ability and productivity as a worker follow independent random processes. Entrepreneurial activity is rewarded with a higher expected income. Similar to Lucas (1978), there is no aggregate risk.