Entrepreneurial Risk and Market Entry

This paper attempts to reconcile the risk-bearing characterization of entrepreneurs with the stylized fact that entrepreneurs exhibit conventional risk aversion profiles. We propose that the disparity arises from confounding two distinct dimensions of uncertainty: demand uncertainty and ability uncertainty. We further propose that entrepreneurs will be risk averse with respect to demand uncertainty, yet “risk-seeking” (or overconfident) with respect to ability uncertainty. To examine this view we model the entrepreneur’s entry decision then test the model empirically. We find that entrepreneurs in aggregate behave as we predict. Accordingly, risk-averse entrepreneurs are willing to bear market risk when the degree of ability uncertainty is comparable to the degree of demand uncertainty. A potential market failure exists however in instances where there is a high degree of demand uncertainty, but low ability uncertainty. In those settings there may be insufficient entry, competition and innovation.