Academic journal article Journal of Economics and Economic Education Research

Adverse Selection and Moral Hazard Problems with Respect to Occupational Choice

Academic journal article Journal of Economics and Economic Education Research

Adverse Selection and Moral Hazard Problems with Respect to Occupational Choice

Article excerpt

INTRODUCTION

A pivotal issue in the disciplines of Economics, Strategy, and Entrepreneurship is the relation between firm size and the propensity to innovate (Cohen and Klepper 1996a). Scherer (1984) first asked why small firms should be more innovative considering that much of the fixed costs of innovation could be more easily borne by large firms (Holmstrom 1989). This notion was epitomized in Schumpeter's 1950 work where he argued that large firms were the drivers of innovation, viewing patent counts as a proxy for innovativeness. However, and in light of Schumpeter's thesis, the exact opposite has been found empirically. Studies concerning firm size and market entry (Agarwal and Audretsch 2001; Brown 2012) suggest that market niches are filled by small firms especially in relation to the stage of the product life cycles of these markets.

Within industries, the number of innovations per dollar of Research and Development (R&D) decreases with firm size with smaller firms accounting for a disproportionately large percentage of innovative measures (Cohen and Klepper 1996a, Bound et al., 1984, Acs and Audretsch 1988, 1991a, Pavitt et al. 1987). A follow up question with respect to innovativeness is what constitutes an innovation? This question has primarily been dealt with by using patent data (Kerr and Fu 2008), which measures direct evidence of a firm's ability to innovate. However, patent data measures only quantity, and not quality, which has led others to measure patent citations (Trajtenberg (1990), Hall, Jaffe and Trajtenberg 2000). Citations may be more indicative of a patent's relative importance in the marketplace for products and ideas. This work will present a model with three agent-level variations based on occupational choice. The choices that will be borne out are that of (i) a salaried production worker, (ii) an entrepreneur who starts a small firm by teaming up with a venture capitalist in a pure equity contract and (iii) a scientist who runs a corporate-sponsored research venture at a large firm for a fixed wage. By introducing heterogeneity in the research sector, and diversity in the types of employers, we create a framework in which both efficient and relatively inefficient research organizations may be simultaneously active in equilibrium. The desired outcome is attained because large firms, by their nature, pool research efforts while entrepreneurial firms attract individuality.

As a prelude to the model developed here, consider a distribution of risk-averse agents indexed by a skill factor that determines one's average productivity at performing research. Agents have three occupational choices. They may become salaried production workers, entrepreneurs that start-up an independent research venture (i.e. a "small" firm) by entering into an equity contract with a venture capitalist, or scientists running a corporate-sponsored research venture at a large firm in exchange for a fixed wage. Individuals that choose a research-based occupation incur a disutility that is decreasing in their skill factor. In the process of innovating, agents are subject to an uninsurable idiosyncratic shock. Employers observe the aggregate output of their operations, but not the individual ability of a researcher. As such, scientists are paid on the basis of their average product at the large firm, which pools the risk of all corporate-sponsored ventures while providing full insurance to its employees. Despite the fact that venture capitalists are unable to observe ability, the income of an entrepreneur is increasing in skill under reasonable assumptions. That is, large firms pay based on average productivity, whereas small firms pay based on individual productivity. In equilibrium, low-skilled agents become production workers; those of intermediate ability become scientists since the disutility of performing research is decreasing in skill; and high-skilled agents launch independent ventures because they obtain a sufficiently high expected income as entrepreneurs that warrant foregoing full insurance at the large firm. …

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