Information frictions and entrepreneurship

• Author: Justin Tumlinson,Deepak Hegde
• DOI: http://doi.org/10.1002/smj.3242
• Published date: 01 March 2021
• Date: 01 March 2021

RESEARCH ARTICLE

Information frictions and entrepreneurship

Deepak Hegde

1

| Justin Tumlinson

2

1

New York University, New York,

New York

2

Loughborough University,

Loughborough, UK

Correspondence

Deepak Hegde, New York University,

New York, NY.

Email: dhegde@stern.nyu.edu

Abstract

Research Summary: Why do individuals become

entrepreneurs? Why do some succeed? We propose two

theories in which information frictions play a central

role in answering these questions. Empirical analysis of

longitudinal samples from the United States and the

United Kingdom reveals the following patterns:

(a) entrepreneurs have higher cognitive ability than

employees with comparable education, (b) employees

have better education than equally able entrepreneurs,

and (c) entrepreneurs' earnings are higher and exhibit

greater variance than employees with similar educa-

tion. These and other empirical tests support our asym-

metric information theory of entrepreneurship that

when information frictions cause firms to undervalue

workers lacking traditional credentials, workers' quest

to maximize their private returns drives the most able

into successful entrepreneurship.

Managerial Summary: Steve Jobs, Bill Gates, Mark

Zuckerberg, Rachael Ray, and Oprah Winfrey are all

entrepreneurs whose educational qualifications belie

their extraordinary success. Are they outliers or do

their examples reveal a link between education and

success in entrepreneurship? We argue that employers

assess potential workers based on their educational

qualifications, especially early in their careers when

there is little direct information on work accomplish-

ments and productivity. This leads those who correctly

believe that they are better than their résumés show to

become successful entrepreneurs. Evidence from two

nationally representative samples of workers (from the

Received: 7 January 2020 Revised: 25 July 2020 Accepted: 18 August 2020 Published on: 14 October 2020

DOI: 10.1002/smj.3242

Strat Mgmt J. 2021;42:491–528. wileyonlinelibrary.com/journal/smj © 2020 Strategic Management Society 491

United States and the United Kingdom) supports our

theory, which applies to equally to the immigrant food

vendor lacking a high school diploma as well as the

PhD founder of a science-based startup.

KEYWORDS

asymmetric information, education, entrepreneurship, job-

matching, signaling

1|INTRODUCTION

Hewlett-Packard apparently denied Steve Jobs' petition for employment in 1977, because he

lacked a degree—Jobs had dropped out of Reed College in 1972. Twitter and Facebook rejected

San Jose State dropout Jan Koum's job applications; a year later he founded WhatsApp!, a com-

pany he would sell in 5 years to Facebook for $19 billion. D. J. Patel's Indian geology degree

was not recognized by U.S. employers when he arrived in 1997, so he worked in the fast food

industry. Now he owns more than a dozen pizza franchises near Atlanta, GA. How general is

the experience of Jobs, Koum, and Patel—all of whom became entrepreneurs after prospective

employers overlooked their talents, evidently due to insufficient credentials?

In this paper, we formalize and test two theories of entrepreneurship that could explain

these successful entrepreneurs' decisions to strike out on their own. Informational frictions

about worker ability lie at the heart of both. The difference between the two lies in who faces

the informational imperfection—potential employers or the worker himself.

The first explanation, driven by asymmetric information, argues that any individual has

incentive to start his own venture if potential employers perceive his productive capacity as

lower than he does. Building on the seminal contributions of Akerlof (1970) and Spence (1973)

to asymmetric information and signaling, we develop a theory in which firms reward workers

with wages based on observable signals of ability. Ability can be inferred from many traits and

behaviors. For example, potential employers commonly accept educational attainment and

work history as signals of unobservable ability. However, the signals are imperfect—if a worker

believes his ability exceeds what potential employers can infer from his observable characteris-

tics, then he chooses entrepreneurship and becomes residual claimant of his productivity,

rather than join a firm in which he would be paid according to his observable signals. We show

that these pressures exist whether signals arise exogenously or workers acquire them endoge-

nously, like educational degrees, and whether they increase the holder's productivity or not.

Comparative advantage drives our second information-based theory of entrepreneurship.

We draw from Roy's (1951) and Jovanovic's (1979) insights that occupational choice results

from matching multidimensional human capital to job-dependent multifactor production func-

tions. Others before us, most prominently Lazear (2004, 2005), have proposed that entrepre-

neurship arises from differentiated abilities but have not derived clear predictions about

entrepreneurial entry and earnings when information about abilities is symmetrically imperfect

(i.e., not known with certainty by either the worker or employer at the outset). We develop a

model in which signals of ability are productive, like the specific skills one acquires through for-

mal education. If these yield relatively more in existing firms, and innate cognitive ability pro-

duces relatively more in entrepreneurship, then workers will eventually sort into the respective

492 HEGDE AND TUMLINSON

occupation where their productivity is highest. The rate at which information imperfection

resolves determines how fast individuals find their optimal mode of work.

Both models generate some similar propositions, particularly in static settings. Both predict

that workers who choose entrepreneurship have higher ability and higher income than

employees with the same signals, while entrepreneurs' signals are inferior to similarly able

employees'. However, only asymmetric information indicates that entrepreneurs' incomes will

exhibit higher variance among workers with the same signals. Dynamic analyses yield further

telltale differences: With the reduction of informational asymmetries over worker careers, the

hypothesized ability advantage of entrepreneurs relative to employees of the same signal dimin-

ishes. On the other hand, the resolution of symmetric informational imperfections predicts the

opposite—as a worker and his (potential) employers simultaneously learn his relative strengths

and weakness, the sorting of workers to matching occupations improves, which increases the

ability gap between entrepreneurs and employees with the same educational credentials

over time.

We test these theoretical predictions using data drawn from the nationally representative

National Longitudinal Survey of Youth (NLSY), first administered to 12,686 individuals born

between 1957 and 1964, and resident in the United States in 1979. The NLSY provides a detailed

record of their education and work histories to the present. Analyzing this sample, we find that

those who become self-employed (or entrepreneurs) scored higher on cognitive ability tests

administered to them as adolescents than employees with similar educational credentials, our

proxy for observable signals. Despite their higher ability scores, the self-employed have lower

academic credentials. In fact, the larger the gap between an individual's own ability and the

median ability of individuals with his same academic credentials, the more likely he is to

choose entrepreneurship. A median self-employed worker earns 7.3% more than a comparably

educated wage-employee, and entrepreneurial earnings have higher variance. These empirical

differences between the self-employed and wage-employed prevail for both self-employed

workers who incorporate their businesses as well as those who do not, with the results on

income and wealth differences being particularly stark for incorporated entrepreneurs—those

most likely to be residual claimants of high growth enterprises. We obtain these results after

controlling for a variety of potential correlates of entrepreneurial choice, including worker

wealth, noncognitive traits such as risk-taking and locus of control, and other demographic fea-

tures. Analysis of a second nationally representative dataset constructed from the U.K. National

Child Development Study (NCDS), which follows the lives of every U.K. resident born during

one particular week in 1958 to the present yields qualitatively similar results.

However, further empirical analyses do not equally support both theories. We find no evi-

dence that the returns to cognitive ability are higher in entrepreneurship or that the returns to

education are higher in wage work—requisite conditions for comparative advantage. Further,

although individuals with high ability relative to their educational pedigree tend to enter entre-

preneurship, the effect attenuates over workers' careers—a pattern consistent with asymmetric

information but contradictory to comparative advantage with imperfect information. Next,

employees' returns to ability increase over time but show no significant evolution for

entrepreneurs—suggesting that employers learn their employees' abilities but entrepreneurs get

paid for their innate talents early on, again supportive of asymmetric information. Although the

above evidence implies workers know themselves better than the labor market, workers' infor-

mation about their own ability is also evidently imperfect, and occupational switching is not

uncommon—those who give up entrepreneurship for wage work have higher credentials than

ability, while employees transitioning to entrepreneurship have relatively higher ability,

HEGDE AND TUMLINSON 493