A GENERAL-EQUILIBRIUM-THEORY OF FIRM FORMATION BASED ON INDIVIDUAL UNOBSERVABLE SKILLS

A model of firm formation is built along the lines of Knight (1921). C ontrary to Kihlstrom and Laffont (1979) the individuals are risk-neutr al but have different productive efficiencies. We suppose that the ind ividuals who are the more efficient workers are also the more efficien t entrepreneurs. Each agent chooses the activity which gives her the l arger expected income. In equilibrium the more efficient people become entrepreneurs and, under a special kind of increasing returns to scal e assumption, this is also what is implied by efficiency consideration s. However we show that the equilibrium number of entrepreneurs is alw ays larger than the Pareto-optimal one. A simple uniform lump-sum tax on firms together with redistribution of the tax revenue to workers is nevertheless sufficient to restore efficiency.