Journal of Economic Behavior & OrganizationVol. 48 (2002) 2936

Low risk aversion encourages the choice forentrepreneurship: an empirical test of a truism

J.S. Cramer a, J. Hartog b, N. Jonker b, C.M. Van Praag c,a Tinbergen Institute Amsterdam, Keizersgracht 482, 1017 EG Amsterdam, The Netherlands

b University of Amsterdam and Tinbergen Institute, Roetersstraat 11; 1018 WB Amsterdam, The Netherlandsc University of Amsterdam, Roetersstraat 11; 1018 WB Amsterdam, The Netherlands

Received 18 November 1999; accepted 15 June 2000

Abstract

Entrepreneurship is historically associated with risk bearing. Consequently, risk attitude is widelybelieved to affect the selection of individuals into entrepreneurial positions. The data support thesupposedly negative effect of risk aversion on entrepreneurship selection. However, we do not feelenough confident about our measure of risk attitude to conclude anything concerning the causalityof this relationship. 2002 Elsevier Science B.V. All rights reserved.

JEL classification: D81; J23; J24; M13

Keywords: Entrepreneurship; Self-employment; Risk-taking; Occupational choice

1. Introduction

It is common knowledge that the rewards of entrepreneurship are more variable and lesscertain than the wages of employment. This stylized fact has been based on substantialempirical support (for instance, in De Wit, 1993).

A logical consequence should be that individuals with a relatively low degree of riskaversion are more likely to opt for entrepreneurship as opposed to wage employment. Thisview was already held by classic authors like Cantillon (1979), Say (1971) and Knight(1971). It has more recently surfaced in models of occupational choice by Kihlstrom andLaffont (1979), Kanbur (1979), and Blanchflower and Oswald (1998). Nevertheless, thiswidely accepted effect of risk aversion discouraging people from entrepreneurship has neverbeen put to an empirical test. We assume that this omission is mainly due to a lack of sample

Corresponding author. Tel.: +31-20-525-4096.E-mail addresses: mars.cram@worldonline.nl (J.S. Cramer), vanpraag@fee.uva.nl (C.M. Van Praag).

0167-2681/02/$ see front matter 2002 Elsevier Science B.V. All rights reserved.PII: S0 1 6 7 -2681 (01 )00222 -0

30 J.S. Cramer et al. / J. of Economic Behavior & Org. 48 (2002) 2936

surveys in which a direct individual measure of risk aversion (and entrepreneurship history)is recorded.

We are in a position to make a first attempt to fill the empirical evidence-gap by meansof a sample survey that we constructed for this purpose (Section 2). It contains sufficientinformation of occupational histories of approximately 1700 individuals along with theirevaluations of a specified lottery and other explanatory variables. The answers to the lotteryevaluation result in a snapshot proxy of individual attitudes towards risk. From this, wederive from utility theory both an empirical measure of absolute risk aversion as well as oneof relative risk aversion (Section 3). These empirical measures are subsequently inserted intoprobit equations explaining self-employment selection, which is the conventional empiricalequivalent of entrepreneurship (Van Praag, 1996). We control for several important otherpotential determinants of self-employment (Section 4). The results suggest that risk aversiondiscourages people from entrepreneurship. The causality of this finding, however, is far fromclear cut. More research into empirical measures of risk attitude is clearly needed (Section 5).

2. Data

The dataset employed, called the Brabant survey initially refers to 5800 schoolchildren.They were interviewed and tested in 1952, all at the age of 12 and in the last grade level ofelementary school in the Dutch province Noord-Brabant. In so far as they could be traced,they were subsequently reinterviewed in 1983 and 1993. The early data cover a rich set ofaptitude scores and parental background variables. The later interviews record labor markethistories, including detailed information on entrepreneurship experiences. Three variablesdeserve a little description.

1. Entrepreneurship: Dependent variable, dummy which takes on the value 1 for individualsthat have ever been self-employed and 0 for all other respondents that have ever beenpart of the labor force.

2. Risk attitude: The last interview in 1993 includes the question how much the respondentwould pay for a ticket in a hypothetical lottery with 10 tickets and a single prize of1000 guilders. 1 This reservation price p reflects the individual attitude towards risk. Adrawback of this measure of risk aversion is its ex post character.

3. Wealth: A monetary measure of an individuals net assets in the last interview year.Recorded as a class variable, in 10 classes. Item non-response is high, our estimateof the quality of the answers given is low. Moreover, one can hardly believe that ameasure of ex post wealth affects occupational choice (if any, the effect would be theother way around). For these reasons, we consider utility functions that presume constantrelative risk aversion, as these should make use of the wealth measure, with great cautiononly.

The inclusion of the other (control) variables in the model is motivated by the existingtheoretical and empirical knowledge base of entrepreneurship (see Van Praag, 1996 for

1 About US$ 500.

J.S. Cramer et al. / J. of Economic Behavior & Org. 48 (2002) 2936 31

a motivation of including these (and no other) variables as determinants, of self-employ-ment). 2

The model is estimated on a subsample of approximately 1500 individuals who have everparticipated in the labor market and for whom the relevant variables are not missing.

3. Measures of risk aversion

In the present context, the reservation price p is the price respondents would pay fora ticket in a hypothetical lottery with 10 tickets and a single prize of 1000 guilders. Ourapproach is to use transformations of it as variables influencing the choice between wageemployment and entrepreneurship in a probit analysis. The novelty of our treatment (if any)lies in the use of a direct measure of risk aversion rather than an ex post revealed attitude.

The simplest way to use the reservation price p as a measure of risk aversion is to considera simple transformation of the reservation price.

Transformed price = 1 p100

, (1)

where 100 is the fair value of the lottery ticket in guilders. A more sophisticated approachis to use the ArrowPratt (Pratt, 1964) measure of absolute risk aversion

= U

U , (2)

where U is a common utility function U(W) of wealth or rewards W. The role of can bedemonstrated in a simple framework. Consider two alternatives X and Y. X offers a certainreward X, and Y gives additional benefits B with probability or irretrievable costs C withprobability 1. The choice between these two options depend on the sign of an indicatorfunction

I = E(UY ) U(X)+K, (3)where the constant K allows for individual characteristics and for other aspects of X and Ythan mere rewards.

In standard expected utility theory,

E(UY ) = U(X + B)+ (1 )U(X C). (4)We approximate both terms by a Taylor series

U(X + B) = U(X)+ BU(X)+ 12B2U (X), (5)U(X C) = U(X) CU(X)+ 12C2U (X). (6)

2 Note that we cannot include any time varying variables, since we explain past labor market decisions. Thoseindividuals that have never become entrepreneurs have not taken this decision in a particular year. This explainswhy variables such as age are not included among the explanatory variables. Moreover, there is another categoryof variables only defined for entrepreneurs; this applies, for instance, to motivation to start as entrepreneur,industry dummies, macroeconomic circumstances in the starting year or specific experience in the industry and/oroccupation selected for entrepreneurship. These are omitted from the analyses too.

32 J.S. Cramer et al. / J. of Economic Behavior & Org. 48 (2002) 2936

By substitution into (4), we findE(UY ) U(X) = {B (1 )C}U (X)+ 12 {B2 + (1 )C2}U (X) (7)

for the operative term of (3).We first apply this expression to the choice between paid employment X (supposedly free

from risk) and entrepreneurship Y at equal expected rewards. This condition impliesB (1 )C = 0 (8)

so that (7) is simplified toE(UY ) U(X) = 12 dB2U (X) (9)

with d equal to the odds ratio

d = (1 ) . (10)

Upon division by U(X) (which is always positive), (9) can be rewritten asE(UY ) U(X)

U (X)= 1

2dB2, (11)

with the absolute risk aversion of (2). It follows at once that, at equal expected rewards,the uncertain alternative Y is the more attractive the lower is the absolute risk aversion.

The same framework can be applied to participation in a lottery as the uncertain optionY. If is the probability of winning a single prize Z and the price of a ticket is p, then thebenefit B equals Z p and the cost C is p. Since purely pecuniary considerations prevail,K of (3) is 0, and participation depends on the sign of (7), or

E(UY ) U(X)= {(Z p) (1 )p}U (X)+ 12 {(Z p)2+ (1 )p2}U (X). (12)

The reservation price p of an individual will make this expression 0. This gives(Z p)U (X) = 12 (Z2 2Zp + p2)U (X), (13)

so that

absolute = U

U = Z p

(1/2)(Z2 2Zp + p2) (14)

and this permits the calculation of the individual absolute risk aversion from the answer tothe lottery question.

It is of course questionable whether the absolute risk aversion or the relative risk aversionis constant and permanent (as it is assumed in the empirical analysis). We therefore introducerelative risk aversion as the third risk measure

relative = (absolute ) wealth. (15)where wealth is the respondents wealth as recorded in the 1993 survey, at the same time asthe reservation price. But this has been measured crudely, by a single question, the repliesbeing classified in a few wide classes.

J.S. Cramer et al. / J. of Economic Behavior & Org. 48 (2002) 2936 33

Table 1Frequency distribution of reservation prices

Reservation price Employees Entrepreneurs

Non-response 52 200 184 551 115 202 43 83 13 05 108 157 1 0

10 472 8012 2 015 10 120 10 025 294 4950 92 2160 1 075 5 080 1 099 1 0

100 142 53110 6 0120 1 0125 2 2150 4 1200 5 4250 2 0500 1 1

Total 1567 330

4. Results

Our measures of risk aversion are based on the observations presented in Table 1 andvisualized in Fig. 1. The figure and table show that reservation prices above 10 guilderscluster at multiples of 25. In Table 2, we have compressed this information in standardintervals of risk attitude. The data clearly suggest that the entrepreneurs are less risk aversethan the employees. 3

In Table 3, each of our three risk variables is introduced in a standard probit analysisof retrospective occupational choice. These respondents have replied to the lottery ques-tion and have been employed or self-employed (or both) at any time in their adult life; ifthey report self-employment at any time, as 15 percent do, this signifies a choice for en-trepreneurship. Apart from risk attitude, five background variables from the 1952 interviewhave been included after a prolonged search for relevant covariates.

3 The absolute level of risk aversion as measured here is extensively analyzed in Hartog et al. (1999). Using thisand two additional datasets, they consistently find risk aversion to be declining in income and wealth, to be lowerfor men than for women and higher for civil servants than for private sector workers.

34 J.S. Cramer et al. / J. of Economic Behavior & Org. 48 (2002) 2936

Fig. 1. Distribution of reservation prices lottery tickets.

Table 2Descriptive statistics

Employees Entrepreneurs

Average S.D. Average S.D.

Reservation price 23.94 34.99 32.91 49.26Absolute 1.5564 103 0.6668 103 1.3836 103 0.8758 103

Number Percent Number Percent

Risk averse 1352 89.24 249 80.32Risk neutral 142 9.37 53 17.10Risk loving 21 1.39 8 2.58

For continuous regressor variables, we report quasi-elasticities, that is the effect of a 1percent change on the probability of entrepreneurship, expressed in percentage points; for0, 1 dummy variables derivatives give their direct effect in percentage points. All coefficientshave been evaluated at the sample mean, and absolute t values are given in brackets. Thetop of the table refers to the three risk measures and wealth, all from the 1993 survey, whichwe discuss presently; the second half lists five background variables. These are gender,educational level, and two parental characteristics. None of the other available variablesproved significantly relevant. Further details are given in the footnote in Table 3.

J.S. Cramer et al. / J. of Economic Behavior & Org. 48 (2002) 2936 35

Table 3Probit analysis of entrepreneurshipa

No. of observation 1787 1787 1787 1699

Quasi-elasticitiesTransformed price 0.11(3.0)Absolute 0.13 (3.1)Relative 0.04 (2.3)Reported wealth 0.18 (9.2)Intelligence 0.38 (2.4) 0.37 (2.2) 0.37 (2.2) 0.21 (1.2)

DerivativesGender 0.27 (5.7) 0.26 (5.2) 0.25 (5.3) 0.22 (4.4)Vocational schooling 0.14 (2.5) 0.15 (2.6) 0.15 (2.6) 0.13 (2.1)Father independent 0.28 (6.3) 0.28 (6.2) 0.28 (6.2) 0.20 (4.1)Father highly educated 0.28 (2.4) 0.28 (2.4) 0.28 (2.4) 0.12 (1.0)log L/n 0.402 0.400 0.399 0.360

a Apart from the risk variables the following variables enter into the analysis. Reported wealth is wealth,summarily recorded in the 1993 survey and listed in broad classes, with several observations negative and manyzero; there is probably severe under-reporting, and the low sample mean will affect relative and contribute to thelow quasi-elasticity. As for the background variables, intelligence is an intelligence quotient with special referenceto abstract reasoning, measured while at school in 1952. Gender has value 1 if female. Vocational schooling is 1 ifthe highest level of education attended, as reported in 1993, is MBO, a vocational type of schooling, often businessoriented, its level somewhat below college. Father independent is 1 if the respondents father was self-employed;and father highly educated is 1 if he held a responsible position which would normally require university education.Both variables have been recorded in 1952. The number of observations in the last column is smaller because ofnon-response in the wealth question. The other analyses are not materially altered if repeated on the smaller subsetof data.

The major finding is that all three measures of risk aversion have a clear negative effect onentrepreneurship. The relative is tainted by its association with reported wealth, which ispoorly measured; this is by itself quite strongly positively related to entrepreneurship, andas a result relative has a positive coefficient unless we control for reported wealth. Theintroduction of this variable then affects the fit as well as the coefficients of the backgroundvariables, which are otherwise immune to the introduction of risk. But reported wealth isa 1993 variable, and jointly endogenous with the individuals work experience. It has verylittle to do with initial wealth, which may well affect the entrepreneurship decision, andthere is no point in including it in the other analyses where it is not needed as a controlvariable.

An additional analysis was performed to obtain insight into the character of the lotterymeasure of risk attitude and into the causality of its relationship with entrepreneurshipselection. Hartog et al. (1999) isolate the significant determinants of our measure of riskattitude by means of the same dataset. They find risk attitude to be a function of both timevarying and other covariates. For our purpose, we only include constant (early childhoodvariables) covariates into the set of explanatory variables of risk attitude. This would, in away, lead to a constant measure of risk attitude, thus excluding variations due to incomeor other variations in individual circumstances over time. By means of a 2SLS approach,we simultaneously estimate both the entrepreneurship decision and risk attitude. This leadsto an insufficient explanation of risk attitude: the estimation results severely suffer from

36 J.S. Cramer et al. / J. of Economic Behavior & Org. 48 (2002) 2936

multicollinearity and the contribution of early childhood variables in the explanation of theindividual variation in risk attitude is very low.

5. Conclusion

We conclude that entrepreneurship is indeed discouraged by the individual degree ofrisk aversion. This conclusion is inevitably subject to serious reservations. The analysisperforce uses a mixture of variables recorded in 1952 and in 1993 in an attempt to explainthe individuals entrepreneurship choices in the intervening years. The three risk aversionmeasures are from 1993, and it is tacitly assumed that they describe an individual traitthat is constant over life. This would seem to hold more readily for absolute than forrelative . But if risk aversion by whatsoever definition is reduced by the experience ofentrepreneurship or by income or wealth this would certainly alter the interpretation ofthe results. The biggest problem with our current approach is probably the timing of theinformation. We only have our indication of risk aversion (long) after the occupationalchoice has been made, and we are not able to deal adequately with the problem of variationin risk attitude over the individuals lifetime with the present data.

References

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Book-Store Co., Tokyo, 1755.De Wit, G. 1993. Determinants of self-employment. Physica Verlag, Heidelburg, Germany.Hartog, J., Carbonell Ferrer, A., Jonker, N., 1999. On a Simple Measure of Risk Aversion. Unpublished Manuscript,

University of Amsterdam, The Netherlands.Kanbur, S.M., 1979. On risk taking and the personal distribution of income. Journal of Political Economy 87,

760797.Kihlstrom, R.E., Laffont, J.J., 1979. A general equilibrium entrepreneurial theory of new firm formation based on

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Chicago, 1921.Pratt, J.W., 1964. Risk aversion in the small and in the large. Econometrica 32, 122136.Say, J.B., 1971. A Treatise o Political Economy or the Distribution and Consumption of Wealth, 1st Edition.

Augustus M. Kelley, New York, 1803.Van Praag, C.M., 1996. Determinants of successful entrepreneurship. Ph.D. dissertation, University of Amsterdam,

The Netherlands.

Low risk aversion encourages the choice for entrepreneurship: an empirical test of a truismIntroductionDataMeasures of risk aversionResultsConclusionReferences