A general equilibrium theory of firm formation based on individual unobservable skills

Abstract A model of firm formation is built along the lines of Knight (1921). Contrary to Kihlstrom and Laffont (1979) the individuals are risk-neutral but have different productive efficiencies. We suppose that the individuals who are the more efficient workers are also the more efficient entrepreneurs. Each agent chooses the activity which gives her the larger expected income. In equilibrium the more efficient people become entrepreneurs and, under a special kind of increasing returns to scale assumption, this is also what is implied by efficiency considerations. However we show that the equilibrium number of entrepreneurs is always larger than the Pareto-optimal one. A simple uniform lump-sum tax on firms together with redistribution of the tax revenue to workers is nevertheless sufficient to restore efficiency.