Occupational Choice and Dynamic Incentives

We study an overlapping generations version of the principal-agent problem, where incentive contracts are determined in general equilibrium. All individuals are workers when young, but have a choice between becoming entrepreneurs or remaining workers when old. Imperfections in the credit market give rise to rents in entrepreneurial activities involving set-up costs. These rents motivate poor agents to work hard and save to overcome the borrowing constraints. With a labor market that is subject to moral hazard, the increased effort raises social welfare. Taxing the rich and subsidizing the poor in order to allow the poor to become self-financed entrepreneurs reduces the incentives for young agents to work hard and save. A reduction of the imperfections in the credit market has the same effect since it reduces the entrepreneurial rents