Modeling productive entrepreneurship in developing countries

This paper develops a model of entrepreneurial start ups in an economy with costly firm creation, costly entry to the skilled labor market, and a mismatch between skilled workers and available jobs, as prevailing in many developing countries. It examines several mitigating policies, such as improving the business environment, reducing tax rates and cost of starting business, and subsidizing entrepreneurial search and skilled employment. To be effective, policies need to target the most binding constraints to productive entrepreneurship. When the constraints are on the side of firms, search subsidies would be more effective in encouraging productive start ups than subsidies to skilled employment, although fewer entrepreneurs may choose to operate in the formal sector than under the latter. Both types of subsidies should be phased out with reforms of the business environment and improved labor markets.