Is the capital function distinct from the entrepreneurial function in modern economies? Or does a person have to be wealthy before he or she can start a business? Knight and Schumpeter held different views on the answer to this question. Our empirical findings side with Knight: Liquidity constraints bind, and a would-be entrepreneur must bear most of the risk inherent in his venture. The reasoning is roughly this: The data show that wealthier people are more inclined to become entrepreneurs. In principle, this could be so because the wealthy tend to make better entrepreneurs, but the data reject this explanation. Instead, the data point to liquidity constraints: capital is essential for starting a business, and liquidity constraints tend to exclude those with insufficient funds at their disposal.

Is the capitalist function distinct from the entrepreneurial function in modern economies? Or does a person have to be wealthy before he or she can start a business? Frank H. Knight and Joseph A. Schumpeter held different views on the answer to this question. The authors' empirical findings side with Knight: liquidity constraints bind, and a would-be entrepreneur must bear most of the risk inherent in his venture. The reasoning is roughly this: the data show that wealthier people are more inclined to become entrepreneurs. In principle, this could be so because the wealthy tend to make better entrepreneurs, but the data reject this explanation. Instead, the data point to liquidity constraints: capital is essential for starting a business, and liquidity constraints tend to exclude those with insufficient funds at their disposal.

About 4.2 million men and women operate businesses on a full-time basis. Comprising more than a tenth of all workers, they run most of our nation’s firms and employ about a tenth of all wage workers. The fraction of the labor force that is self-employed has increased since the mid-1970s after a long period of decline.1 This paper examines the process of selection into self-employment over the life cycle and the determinants of self-employment earnings using data from the National Longitudinal Survey of Young Men (NLS) for 1966–1981 and the Current Population Surveys for 1968–1987.