Entrepreneurship: Cause and Consequence of Financial Optimism

• Author: Christopher Dawson,Andrew Henley,G. Reza Arabsheibani,David de Meza
• DOI: http://doi.org/10.1111/jems.12076
• Date: 01 December 2014
• Published date: 01 December 2014

Entrepreneurship: Cause and Consequence of

Financial Optimism

CHRISTOPHER DAWSON

School of Management

University of Bath

Bath BA2 7AY, UK

cgd26@management.bath.ac.uk

DAVID DE MEZA

Department of Management

London School of Economics and Political Science

London WC2A 2AE, UK

d.de-meza@lse.ac.uk

ANDREW HENLEY

School of Management and Business

Aberystwyth University

Aberystwyth SY23 3AL

United Kingdom

and IZA Bonn, Germany

a.g.henley@aber.ac.uk

G. REZA ARABSHEIBANI

School of Management

Swansea University

Swansea SA2 8PP,United Kingdom

and IZA Bonn, Germany

g.arabsheibani@swansea.ac.uk

Extant evidence that the self-employed overestimate their returns by a greater margin than

employees is consistent with two mutually inclusive possibilities. Self-employment may foster

optimism or intrinsic optimists may be drawn to self-employment. Previous research is generally

unable to disentangle these effects because of reliance on cross-sectional data. Using longitudinal

data, this paper finds that employees who will be self-employed in the future overestimate their

short-term financial wellbeing by more than those who never become self-employed. Optimism

is higher still when self-employed. These results suggest that the greater optimism of the self-

employed reflects both psychological disposition and environmental factors. By providing greater

scope for optimism, self-employment entices the intrinsically optimistic.

“The presumptuous hope of success seems . . . ..to entice so many adventurers

into those hazardous trades, that their competition reduces their profit below

what is sufficient to compensate the risk” Adam Smith, Wealth of Nations

(1796), Book 1, Chapter 10.

We very much appreciate comments from GeorgeBulkley, Vikram Pathania, Steve Pischke, Diane Reyniers,

Yona Rubinstein, two referees,and an associate editor.

C2014 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume23, Number 4, Winter 2014, 717–742

718 Journal of Economics & Management Strategy

1. Introduction

Most governments encourage entrepreneurship on the assumption that it is unequiv-

ocally a good thing, promoting market competition, innovation and economic growth.

For individuals, the attractions of self-employment include personal autonomy, the op-

portunity to take risk for financial reward, life-style flexibility, and tax avoidance (e.g.,

Scheinberg and McMillan, 1988; Dennis, 1996; Amit et al., 2001; Douglas and Shepherd,

2002; Cassar, 2007). If, as Hamilton (2000) finds, median self-employment income is

lower than that in paid employment, or as Moskowitz and Vissing-Jorgensen (2002)

report, starting a business involves higher risk but lower expected returns than for stock

market investment, these may be prices worth paying.1As long as nascent entrepreneurs

appreciate the trade-offs, there is no particular cause for concern. However, accumulat-

ing evidence suggests that the self-employed overestimate their prospects by more than

employees do. This does not necessarily mean that entry into self-employment is exces-

sive. Those selecting self-employment may have an optimistic disposition, in which case

they will also tend to overestimate their prospects in paid employment. If returns are

exaggerated to the same extent in both activities, the choice of employment mode will

be the same as if expectations are realistic. It is only if individuals are more optimistic

about self-employment than paid-employment that entry will be excessive. As planning

and running a new business are activities that involve a high perception of self-control

and offer few barriers to fantasy, they may be fertile conditions for optimism.

Previous research fails to disentangle these effects because it addresses potential

associations between optimism and choice of employment mode using cross-sectional

data. Consequently, the issue of whether a predisposition towards optimism leads in-

dividuals into business formation activity or whether business formation encourages

overoptimistic expectations remains unresolved. Does the relative optimism of the self-

employed reflect their intrinsic psychology or is it a side effect of planning and running a

new business? According to de Meza and Southey (1996), both elements must be present

if optimism is to be a cause of self-employment. Were it equally easy to be optimistic

concerning prospects in self-employment and paid employment there is no particu-

lar reason why intrinsic optimists should be especially attracted by self-employment.

Investigation of this issue is only possible with longitudinal data.

To investigate these matters, this paper uses data on a large sample of individuals

in the United Kingdom tracked annually since 1991. This data source is rich in the sense

that it allows sequential observation of financial expectations, financial realizations, and

transitions into and out of self-employment. However, as explained in the paper, the

categorical nature of the data presents various research challenges.

The key finding of the paper is that the future self-employed display above average

financial optimism even while in paid employment and their optimism becomes greater

still on becoming self-employed. Those choosing self-employment in the future arethere-

fore intrinsically more optimistic than those who do not. Moreover, self-employment

encourages optimism.

The remainder of the paper is structured as follows. Section 2 describes the back-

ground to the questions, identifies some problematic research issues, and proposes

strategies to address them. Section 3 describes the longitudinal data source and devel-

ops the empirical methodology. This is applied in Section 4. Section 5 provides final

discussion and conclusions. An appendix presents alternative empirical approaches.

1. Levine and Rubinstein (2013) find that the incorporated self-employed do better than when in paid

employment.