Abstract
The Lucas (1978) model is extended to incorporate heterogeneity in working ability and a time allocation decision by entrepreneurs (work versus manage). Financial frictions distort not only the average skill of entrepreneurs but also the average skill of workers. The model economy accounts for half of the association between entrepreneurship and external finance to GDP in the data, whereas a standard span of control model explains only about one tenth. The variation in entrepreneurship is mostly due to the variation in self-employed entrepreneurs rather than in employers. Moreover, financial frictions have larger effects on output per worker, TFP, and inequality.
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