Employment vs. Entrepreneurship : Risk Aversion and Occupational Choice

We develop an equilibrium model where risk-averse agents can choose between employment and entrepreneurship. An important property of our framework is that the effort of agents is not observable (moral hazard), so that optimal employment contracts must be incentive compatible. In equilibrium we show that more risk-averse agents tend to select into employment. However, we show that income risk is not the only driver for the occupational choice of agents with entrepreneurship options - as commonly argued. Instead, more risk-averse agents with those options have a lower valuation of entrepreneurship, and are therefore less costly for firms to employ. In equilibrium firms in industries where such options are prevalent then adjust their employment contracts to attract the more risk-averse agents