Relative Wealth Concerns and Entrepreneurship By MANOJ ATOLIAw and KISLAYA PRASADz wFlorida State University zUniversity of Maryland Final version received 5 March 2009. We develop a model of entrepreneurship in which market frictions limit the possibilities for diversifying entrepreneurial risk. A concern for relative standing arises even though individuals consume only standard commodities. In contrast to complete markets, an increase in sector-specific aggregate risk increases entrepreneurship due to relative wealth concerns. A change in the profile of the economy to include more risk-averse people results in an even greater increase in entrepreneurship. Thus relative wealth concerns mitigate the reduction in entrepreneurship arising from the non-diversifiability of entrepreneurial risk. We examine the effects of uncertainty about economic policies such as market-based reforms on entrepreneurship. INTRODUCTION The notion that people are motivated by a desire for rank and social status has a long history in economics (e.g. Smith 1759, pp. 50–8). Despite this, the idea has remained peripheral to the main concerns of economists. The reason is not its lack of descriptive accuracy, but rather the widespread belief that allowing utility functions to be affected by such things as a desire for social status would result in models that have no predictive power (Cole et al. 1995, p. 12). This view has not gone unchallenged, and there have been notable recent attempts to incorporate a concern for relative standing into economic models. Relative wealth concerns have been modelled as a feature of preference, whereby the utility function is an increasing function of the rank in the income distribution (e.g. Robson 1992), or of a ‘status good’ (as in Becker et al. 2005). Relative wealth concerns can also arise in settings where agents consume only standard commodities (Cole et al. 1992, 2001; DeMarzo et al. 2004). This happens, for instance, when access to some good depends on rank in the income distribution. In this paper, we develop a model of relative wealth concerns of this latter variety, and use it to analyse occupational choice and entrepreneurship. While many of our ideas can be applied to the choice between any two occupations differing in the risk profile of earnings, we view the choice between entrepreneurship and wage employment as the most natural example. Thus the key decision facing an agent in our setup is whether to take up wage employment or to become an entrepreneur. 1 Choices are shown, at the margin, to be driven by a desire for higher relative wealth. In the context of a general equilibrium model, we trace out several consequences of such preferences. One of the more interesting margins on which status preference has been shown to make a difference is the propensity to bear riskFa conclusion of the literature being that the desire for rank leads to an increased preference for risk. A similar effect arises in our framework, where relative wealth concerns are shown to lead to an increase in entrepreneurship and risk-taking. In our model, entrepreneurial risk is not diversifiable and, as a consequence, there is less entrepreneurship than would be the case with complete markets. Relative wealth concerns are shown to mitigate this difficulty. Relative wealth effects are shown to be especially plausible when there is uncertainty about economic policy, such as the implementation of market-based reforms. The model allows Economica (2011) 78, 294–316 doi:10.1111/j.1468-0335.2009.00812.x r The Authors. Economica r 2009 The London School of Economics and Political Science. Published by Blackwell Publishing, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main St, Malden, MA 02148, USA