Date Added: Mar 2011
An entrepreneur faces substantial non-diversifiable business risk and liquidity constraints, both of which the authors refer to as frictions. They show that these frictions have significant economic effects on business start-up, capital accumulation/asset sales, portfolio allocation, consumption/saving, and business exit decisions. Compared with the complete-markets benchmark, these frictions make entrepreneurs invest substantially less in the business, consume less, and allocate less to the market portfolio. The endogenous exit option provides flexibility for the entrepreneur to manage downside risk. The entrepreneur's optimal entry decision critically depends on the outside option, the start-up cost, risk aversion, and wealth.