Risk-Bearing, Entrepreneurship and the Theory of Moral Hazard∗

The theory of moral hazard distinguishes two fundamental tradeoffs, one between risk sharing and incentives, and the other between surplus extraction and incentives. This paper isolates the former tradeoff and uses it to examine the “Knightian” theory of entrepreneurship, in which entrepreneurs provide insurance to workers by paying fixed wages, and profits are the residual from risk bearing. Existing models of entrepreneurship are extended by allowing for endogenous risk bearing not only via self-selection into occupations, but also through optimal insurance contracts. Moral hazard prevents full insurance; increases in the agent’s wealth then entail increases in risk borne. Thus, even under decreasing risk aversion, there are robust instances in which workers are wealthier than entrepreneurs. This empirically implausible result suggests that risk-based explanations for entrepreneurship are inadequate. Along with a related result showing that the more highly paid a worker is, the more he should be monitored, it can help to distinguish the empirical relevance of the two fundamental