Self-Employment, Efficiency Wage, and Public Policies

By Kumar, Alok | Economic Inquiry, October 2012 | Go to article overview

Self-Employment, Efficiency Wage, and Public Policies


Kumar, Alok, Economic Inquiry


I. INTRODUCTION

Self-employed workers constitute an important segment of the labor force. In Organization for Economic Cooperation and Development (OECD) countries, the proportion of self-employed workers varies between 8% and 30% (Blanchflower 2004). In many developing countries they constitute the majority of workers (Gollin 2008).

In this article, I develop a model of self-employment which allows for transitions between unemployment and self-employment. I analyze the effects of tax and labor market policies on the self-employment rate and the transition between unemployment and self-employment. This study is motivated by the substantial empirical evidence of transitions between unemployment and self-employment and the empirical literature linking higher unemployment benefits to lower rates of self-employment.

Empirical evidence from several countries shows that unemployed workers are two to three times more likely to become self-employed than wage-employed workers (e.g., Evans and Leighton 1989 for the United States, Kuhn and Schuetze 2001 for Canada, and Carrasco 1999 for Spain). There is a view that many individuals choose self-employment due to limited job opportunities (Alba-Ramirez 1994; Blanchflower 2004; Storey 1991).

At the same time, there is substantial empirical evidence that a higher unemployment benefit is associated with a lower rate of self-employment. Carrasco (1999) finds that a higher unemployment benefit reduced the transition rate of unemployed workers to self-employment in Spain. Parker and Robson (2000) find a significant negative association between unemployment benefits and self-employment in OECD countries.

The transitions between unemployment and self-employment and factors affecting them are also very important policy issues. Governments in many countries consider self-employment to be a possible solution to their unemployment problem. Many countries (e.g., Australia, Germany, United Kingdom, and United States) have introduced government programs to encourage unemployed workers to become self-employed.

Existing models of entrepreneurship (self-employment) typically assume a perfectly competitive environment in the labor market in which there is no unemployment (e.g., Kanbur 1979, 1981; Kihlstrom and Laffont 1979; Lucas 1978). In these models, workers choose between wage employment and entrepreneurship. The absence of unemployment in these models and their static nature preclude the analysis of transitions between self-employment and unemployment and factors affecting them.

In this article, I integrate two strands of theoretical literature--models of occupational choice and models of efficiency wage to explain the above-mentioned empirical findings. In particular, I embed the shirking model of Shapiro and Stiglitz (1984) in the occupational choice framework. Shapiro and Stiglitz's model is one of the most influential models of unemployment. Dickens et al. (1989) provide evidence with regard to the importance of worker theft and shirking and argue that these phenomena are essential to understand the labor market. In addition, this model is highly tractable analytically.

The model developed in this article distinguishes among three labor market states: self-employment, wage employment, and unemployment. Agents in the model can choose to be either self-employed or wage workers in any time period. Wage workers can be unemployed or wage (or salary) employed. Self-employed workers create firms and hire workers to produce.

This article focuses on the flows between unemployment and self-employment. In this model, only unemployed workers choose to become self-employed in equilibrium. I do this because existing models allow workers to choose only between employer status (entrepreneurship) and wage employment and ignore the flows between unemployment and self-employment. I view my model as shedding light on a very important, largely neglected, and interesting component of self-employment. …

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