Firm Foundations and Human Capital Investments : the O-Ring Approach to Organizational Equilibrium in an Emerging Industry

The current analysis introduces human capital investments which - as all other investment projects - must be carried out given ex-ante uncertain returns. This return uncertainty reflects that particular ex-post ability realizations may or may not induce the possibility to engage in profitable entrepreneurial activity. Managed firms which recruit randomly while offering a certain wage-income cannot be kept from entering the industry. However, if it is individual beneficial to seek employment in such firms, given that human capital investments are sunk, the resulting industry structure provides less incentives to invest than a purely entrepreneurial industry. While it remains true that entrepreneurial firms - if they exist - are founded by teams of superior realized abilities, the equilibrium analysis reveals a rather different perspective of the incentive mechanism. Human capital investments are not so much necessary in order to induce entrepreneurial activity. Rather, entrepreneurial activity provides the effective incentives to invest in human capital. This distinction is important to note. Due to the risk-shifting property associated with employment in managed firms, policies directed at maximizing entrepreneurial activities will generally fail to implement an efficient solution. As with every other incentive mechanism, incentive compatibility constitutes a constraint on the possibility to achieve a first-best solution.