A reconciliation of the unemployment — New firm startup paradox

Abstract

The purpose of this paper is to reconcile the seeming paradox emerging in the literature relating unemployment to new-firm startup activity and the decision to enter into self-employment. On the one hand time series studies have generally found that entrepreneurship is promoted by high levels of unemployment. On the other hand, cross-sectional studies have generally found that startup activity tends to be depressed where unemployment is high. We present a model derived from Knight's theory of individual choice in order to reconcile this apparent paradox. Assuming presence of an economy-wide demand shock and industry-specific shocks, the model indeed predicts the relations between new firm startup and unemployment which are found in empirical analysis. Hence, instead of blaming specification errors or unobserved policy changes, the seeming paradox can be reconciled by solid economic theory.