Who Creates New Firms When Local Opportunities Arise?

A growing theoretical and empirical literature shows that new business formation is key to understanding how economies respond to economic shocks. For example, new firms generate the majority of jobs created in response to fluctuations in local demand or following oil and gas discoveries.

The magnitude of the firm entry response to economic shocks depends ultimately on the existence of individuals in the population who are capable of identifying new economic opportunities when they arise, and who are then willing and able to transition to entrepreneurship to exploit them. However, little is known about the characteristics of such responsive individuals who are alert to and act upon rising opportunities.

Understanding the characteristics of these individuals is particularly salient. First, if these responsive individuals are concentrated in particular demographics or have certain specialized traits, then the composition of the local population may have significant implications for the entrepreneurial responsiveness and dynamism of the local economy. Second, when the economy is expanding following positive economic shocks, and more individuals are drawn to entrepreneurship, these “responsive entrepreneurs” may differ in meaningful and policy relevant ways from other entrepreneurs also operating in the economy. For instance, responding quickly to changing market conditions may require a degree of flexibility in one’s personal circumstances not required by other forms of self-employment. Finally, understanding the key traits of such responsive individuals may be important to policymakers in thinking about how to nurture latent entrepreneurial potential and foster vibrant local economies.

To explore this question, we choose to study the Brazilian economy. This setting allows us to use administrative employer-employee matched data from the Brazilian Ministry of Labor, which capture all the employees in the formal sector, and include information on their work history, wages, education, and occupation. Second, the large agribusiness sector in the Brazilian economy allows us to identify exogenous local demand shocks arising from global commodity price fluctuations, and to study the firm creation response.

Specifically, municipalities that specialize in agricultural crops that experience a rise in global commodity prices see an increase in local wages and entrepreneurial activity. At the top 10% of commodity price increases, municipalities experience a 7.8% increase in local aggregate income and a 6.9% increase in local employment. This increase in local aggregate income creates new investment opportunities in sectors that are dependent on local demand, which in turn lead some paid employees to switch into entrepreneurship. Indeed, we find that the local demand shock does trigger significant firm entry, driven almost entirely by increases in the non-tradable sector.

The detailed data allows us to explore the personal and career characteristics of the individuals who create new firms in response to local demand shocks. We start by focusing on the role of age in driving entrepreneurial responsiveness. On the one hand, we might expect older individuals to be more responsive, as they may have had the time to accumulate the experience, skill, and wealth needed to exploit new opportunities. Perhaps surprisingly, however, we find that the responsive entrepreneurs are almost entirely young individuals (less than 30 years old). Specifically, within municipalities that experience a large positive (top-decile) commodity price shock, entrepreneurship increases by almost 15% among individuals at the bottom quartile of the age distribution, while there is essentially no response for older individuals.

Our findings are consistent with the idea that lifecycle considerations strongly influence an individual’s decision and ability to quickly respond to new local economic opportunities by forming a new venture. Indeed, younger individuals have been shown to have higher degrees of risk tolerance than older individuals, and thus may be better able to tolerate risks associated with a fast transition to entrepreneurial activity. Likewise, young individuals may have less constraints in the form of family or looming retirement needs, and may therefore have sufficient flexibility to quickly respond to changes in economic opportunities.

We next show that individual skills also appear to be key drivers of the firm creation response. We find that, among the young, more educated individuals are more responsive to local economic shocks by forming new firms. This is also the case for individuals who previously worked in positions requiring managerial and general business skill sets.

Finally, we further argue, through the lens of supporting empirical evidence, that this individual-level heterogeneity implies that specific features of the local economy, such as demographic composition, degree of formality, availability of financing, and availability of skilled human capital, can have significant aggregate implications for the ability of the local economy to generate new entrepreneurial activity in response to changing market conditions. Together, this evidence highlights how individual characteristics of the population can generate aggregate implications to  the entrepreneurial responsiveness of the economy.