2006-Education, Institutions and Growth - The Role of Entrepreneurus-JDE-Final

Institutions, Education, and Development:
The Role of Entrepreneurs
Joilson Dias
Department of Economics, Universidade de Maringá, Paraná, Brazil
John McDermott
Department of Economics, University of South Carolina, Columbia, USA 29208
March 7, 2005
 We would like to thank Marvin Goodfriend, Kin Blackburn, Jan Breuer, Areendam Chanda, Eric Johnson,
Melayne McInnes, and John Seater for helpful comments.

Abstract:
Education, Institutions, and Growth: The Role of Entrepreneurs
Entrepreneurs are instrumental for structural transformation. They create and

organize new firms and hire workers with a minimum level of human capital. Entrepreneurs
encourage workers to invest in their own education in order to move into the modern
production sector. Better institutions lead to less income diversion, which creates a greater
supply of entrepreneurs, a larger demand for human capial, and faster structural
transformation. Education policy alone is not as effective, although it, too, raises the
number of entrepreneurs. Simulations and evidence from Brazilian states support the
theory. (JEL O15, O38, I20)
Joilson Dias
Economics Department
University of Maringá
Paraná, Brazil
John McDermott
Economics Department
University of South Carolina
Columbia, SC 29208
803.777.4939
dynamo@moore.sc.edu
Entrepreneurs and Growth
1 Introduction
Educational improvement has been a key element in many development strategies,
yet in empirical research the link between human capital formation and development is often
weak. Providing access to schooling does not always lead to high living standards or high
growth rates.1 Institutional quality — in the form of protection of property rights, openness,
and adherence to the rule of law — seems to be more closely related to cross-country living
standards.2 Our position in this paper is that institutional reform is necessary before
educational policy can be effective, since entrepreneurs cannot arise in numbers unless there
is a certain level of property protection. Entrepreneurs, in turn, provide unique services to
the general economy: they hire workers with threshold human capital and provide an
environment within which human capital can be efficiently accumulated.
Entrepreneurs organize and combine factors of production in firms.3 In this paper we

concentrate on two of their effects, one internal and one external. First, they use educated
workers to produce output. Without entrepreneurs, such educated workers would be forced
to take jobs that did not adequately use their skill; their wage would suffer. Second, the more
entrepreneurs in existence, the more productive is learning by individuals. As a result, in
societies short on entrepreneurs workers choose to invest little in education, even though it
may be available at low cost. But where do entrepreneurs come from in the first place?
Some contend that the supply is inelastic and constitutes a key bottleneck to development.
For others, like Hirschman (1958), the supply of productive entrepreneurs is always latent in
the population, and can be summoned relatively quickly if the institutions and the rules they
determine are conducive to such activity. Recently, Baumol (1990) has articulated this view
persuasively in a historical context, noting that activities that we would not normally call
1 See Benhabib and Spiegel (1994) and Lant Pritchett (2001) for examples of empirical work that find little
connection between education or human capital and growth.

2 See, for example, Hall and Jones (1999) and Acemoglu, Johnson, and Robinson (2001).
3 The classic treatment is J. A. Schumpeter (1934).
1
entrepreneurial — like war and tax farming — are exactly that if such activities are
rewarded in money and prestige. This view, which we think is largely correct, transfers
attention from the supply of entrepreneurs back to the institutions of society that channel
their activities.
Highlighting the role of entrepreneurs in growth has been formalized recently in the
work of Murphy, Shleifer, and Vishny (1991), Schmitz (1989), and Iyigun and Owen
(1999). The first assumes that people are endowed with a different innate talent level; in
equilibrium the more talented become entrepreneurs and hire the less talented. Growth,
however, is modeled only as a pure externality: the greater the talent level of the most
talented entrepreneur, the greater the rate of growth. This becomes an important
consideration when they admit the possibility that some talented individuals may decide to
become rent-seekers instead of productive entrepreneurs. Schmitz (1989) presents a similar
model to analyze the implications of spillovers in knowledge formation. In Iyigun and Owen
(1999) agents with a continuum of abilities exist in an OLG framework. The low-ability tier
become workers while the higher ability agents accumulate two different kinds of human
capital, entrepreneurial capital (from working) or professional capital (from going to
school). As countries develop, more professional, and less entrepreneurial, capital is
accumulated.
Our focus is different. We are primarily interested in the structural transformation in

which workers migrate from a traditional production sector to a modern, urban sector where
they work in firms created and managed by productive entrepreneurs. Accumulation of
human capital by workers is a key part of that process. This structure allows us to comment
on two types of policies: institutional policy (which facilitates the creation of entrepreneurs)
and educational policy (which helps workers acquire knowledge or human capital). When
the transition is complete, the economy settles into a balanced growth path.
In our model, people are born as either workers or managers and can not switch
between categories later in life. Within each class, however, agents can choose. Workers can
choose to work in the traditional sector or the modern sector, but if they choose to migrate
to the modern sector they must acquire a minimum amount of human capital. Managers
likewise face a choice: they can elect to be either productive managers (i.e entrepreneurs) or
2
unproductive managers (rent-seekers). If a manager chooses to be an entrepreneur, however,

he faces an entry cost to start a firm and once in business must pay a tax to those who have
remained as unproductive rent-seekers. We show below that the greater the number of
entrepreneurs, the more workers migrate, and those that have migrated acquire more human
capital.
Government policy can operate either to improve education — by reducing the cost
of acquiring the knowledge necessary to migrate — or to improve institutions — by
reducing the entry cost and tax that entrepreneurs must pay. Both policies are effective at
speeding the transition from the traditional to the modern economy. Simulations show,
however, that cutting the marginal tax rate on entrepreneurs is more effective than in any
other policy in raising living standards within a 50-year horizon. This result holds up when
we modify the model, either to allow a feedback effect from human capital to reduce the tax
rate, or to add an outright subsidy to education. At least for our specifications, it appears
that raising the demand for education through institutional reform (cutting the tax on
entrepreneurs) is superior to increasing the supply of education (reducing its cost to
migrants).
We test the basic hypothesis — that a larger stock of entrepreneurs leads to more
human capital formation — with panel data from Brazilian states. Our results support our
hypothesis that states with more entrepreneurs have higher educational achievement among
the young.
In this paper we combine aspects of earlier work on entrepreneurs and firm size with
work on long-run structural change. Lucas (1978) and Calvo and Wellisz (1980) explored
the implications for firm size and efficiency of heterogeneous entrepreneurs interacting with
homogeneous labor. They were concerned with the implications of exogenous technical
change on the number of entrepreneurs (firms) and the distribution of income. In this paper,
our concern is with the transition to a modern economy from a more primitive economy and
the role of entrepreneurs in that process. Recent papers in this tradition include Goodfriend
and McDermott (1995), Galor and Weil (2000), and Hansen and Prescott (2002). These
papers do not include a special role for entrepreneurs or public policy and in most cases firm
size is not determinant. Rather, the focus is on finding a combination of exogenous secular
3
trends and endogenous triggers that propel economies through recognizable historical
phases. Here, we are concerned with a similar transition, but at a much shorter time horizon,
and the focus on entrepreneurs and education allows us to comment on government policy.
If growth depends on the ability to utilize technology from abroad, then the
acquisition of human capital takes on additional importance. This is the question of
absorptive capacity (Nelson and Phelps, 1966; Keller, 1996, 2004). It is not difficult to
imagine that human capital helps people absorb new ideas generated in other countries. This
is one more reason to be concerned with policies to promote education: it allows an increase
in the rate of general knowledge acquisition.
The paper is organized as follows. In the next section we discuss the basic set-up of
the production side of the model. Sections 3 and 4 derive the equilibrium conditions for
learning and migrating, for a given number of entrepreneurs. Section 5 shows how the stock
of entrepreneurs is determined by the institutional environment. Section 6 describes the pre-
growth stationary state, in which workers do not find it worthwhile to accumulate human
capital. In Section 7 we simulate the basic model and show the importance of institutional
reform compared to educational reform. To gain greater insight, we extend the model in
Section 8 by adding a feedback from education to institutions and an education subsidy.
Still, institutional reform dominates. We look at the evidence from Brazilian states in
Section 9. Finally, Section 10 offers some conclusions.
2 Production
There are two sectors in the economy, the traditional and the modern, each producing
an identical consumption good. In the traditional sector, unskilled workers work with a
simple, constant-returns technology. The production function is given by:
YT = AT LT = wT Lt ,
where AT is an exogenous productivity parameter. Since there is only one factor of

production the traditional wage in real terms is given by wT = AT . Workers supply labor
!
inelastically at 1 unit per day, so per capita income and the wage are identical.
In the modern sector, output is produced by firms organized by entrepreneurs. We do

!
4
not make distinctions between different kinds of firms, and assume that all business
organizations require at least one person of “entrepreneurial ability”. The idea that we want
to explore is that firms do not just spring up out of nowhere. They arise because people
organize them, these people — the entrepreneurs — have certain innate abilities not
possessed by workers (Schumpeter, 1939; Kaldor ,1960). That said, we do not delve more
deeply into the actual duties performed by entrepreneurs and do not make distinctions
between different kinds of firms: all firms require an entrepreneur. We do not distinguish,
either theoretically or empirically, between corporations, partnerships, or single proprietors.
There are E entrepreneurs who hire human capital to produce the single consumption
good. Each entrepreneur faces a production function of the form " = AM z # , where AM
represents modern-sector technology, 0 < β < 1 is a parameter, and z is the amount of
human capital hired by the representative entrepreneurial firm. The net income or profit of
!
the firm is given by:
(1) y = AM z " # wz ,
where w is the wage per unit of human capital. To maximize profit, taking w as given, the
demand for human capital by each entrepreneur is given by:
!
d # "AM &)
(2) z = % ( ,
$ w '
where α= 1/(1-β) > 1. Since there are E identical entrepreneurs, the total demand for human
capital is given by:
!
# "A &)
H D = zdE = % M ( E .
$ w '
If the market for human capital clears, the real wage in equilibrium is given by:
! # E &1) " "A
(3) w( z) = " AM % ( = 1)M" ,
$H' z
H
where H is aggregate human capital and z " is the human capital intensity of the
E
!
modern economy. We call w the base wage, since it can be interpreted as the wage of a
!
5
worker with one unit of human capital (h =1). Without loss of generality, we assume that 1
is the minimum amount of human capital necessary to work in the modern sector. Aggregate
human capital is given by:
(4) H = eW hLM ,
where LM is the number of workers in the modern sector, h is the human capital of the
representative worker, and e!
W is the amount of effort expended in work (as opposed to
learning, dealt with below). This formulation is standard and means that the actual wage of a
worker, for a given z, is proportional to her human capital:
"AM h
wage = w( z) h = .
z1# "
If there should be more human capital, either because the number of educated workers LM
rises, or because those
! educated workers acquire more knowledge h then the base wage w in
(3) would decline, although less than proportionally. That means that an individual worker is
always better off with more human capital, even if all modern-sector workers have more
human capital.
Finally, to find entrepreneurial income, we use (1), along with (3) for w:
(5) y ( z) = (1" # ) AM z # .
3 Learning
!
Growth in the modern sector takes place through the accumulation of knowledge h
by individual workers. We assume that there is no technical change (AT and AM are
constant) and examine the role of entrepreneurs in growth by letting modern sector workers
choose the amount of effort they devote to work eM and learning eL , where:
eW + eL = 1 .
When an individual devotes effort eL to learning, her knowledge grows according to:
(6) ! h˙ = " ( E ) heL ,
!
6
where δ ´(E) > 0. In (6), the productivity of one’s time in generating new human capital
depends on one’s initial human capital and on the national stock of entrepreneurs. The
inclusion of the individual (or the economy-wide average) level of human capital h in the
knowledge-accumulation equation has become standard in the growth literature (e.g. Lucas,
1988; Becker, Murphy, and Tamura, 1990; Rebelo, 1991). We adopt a proportional form for
this effect, since it simplifies the mathematics and generates a simple expression for the
allocation of effort.
We also assume that there is a positive external effect from the number of
entrepreneurs E in the modern sector of the economy as summarized by the δ ( E ) function.
There are several reasons for believing that a greater number of entrepreneurs in an
economy would facilitate the accumulation of knowledge by workers. Among them are the
following:
• Urban environment. Workers learn from each other. The greater the number of
entrepreneurs, the larger the modern, urban sector and the better the cooperation and
communication among workers.
• Diversity of firms. More entrepreneurs means a greater number of different kinds of

goods. Workers, who often switch jobs, encounter a variety of processes and
techniques, which may enhance their ability to learn.
• Opportunities and requirements. It is in the interests of the entrepreneurs to have

more educated workers, so they may facilitate (or even demand) worker education
and training, both directly and indirectly (schools, libraries, clubs).
• International contacts. Nations with a large stock of entrepreneurs are likely to have
greater contacts with firms in other countries. New ideas of this type make it easier
for workers to accumulate h.
In their model, Murphy, Shleifer, and Vishny (1991) assumed that growth in general
knowledge depended entirely on the ability of the most talented entrepreneur of the time
period. In earlier work, one of us (Goodfriend and McDermott, 1998; McDermott, 1999)
assumed that human capital growth was facilitated by familiarity interacting with
international technical knowledge. Spillovers on one kind or another have long been
7
considered an important source of knowledge accumulation, although it is not easy to

quantify their effect on either human capital or technology (Keller, 2004).
Assuming people have logarithmic utility, the learning structure assumed here results
in simple solutions for eW and eL . As we show in Appendix A, each modern-sector worker
would split her time as follows:
# r
% " E if " ( E ) > r
% ( )
(7) eW = $ ,
% 1 otherwise
%
&
$ r
&1" # E if # ( E ) > r
! & ( )
(8) eL = % .
& 0 otherwise
&
'
where r is the rate of interest. This behavior leads to human capital growth of:
(9) ! h˙ = [" ( E ) # r ] h ,
when productivity δ ( E ) is greater than r. If it is not, then the economy is in the no-learning
corner: eL = 0, eW = 1, and h˙ = 0 .
!
The no-growth corner is a possibility that we think is important. Consequently, in
what follows we assume
! that there is a critical value of E called Ec such that for E < Ec ,
then δ ( E ) < r. Only if the number of entrepreneurs exceeds Ec will learning productivity
be sufficiently great to encourage people to spend time learning. Past this threshold, the
model has a so-called “scale effect”, in that the growth rate of human capital, not just the
number of educated workers, depends positively on the stock of entrepreneurs.
H
Combining (4) and (7), the human capital intensity ratio z = becomes:
E
8
# r hLM
% if " ( E ) > r
% "(E)E
(10) z = $ .
% hLM
otherwise
% E
&
This ratio enters into the expressions that determine the base wage (3) and entrepreneur
profit (5).
!
4 Migration
The decision to migrate depends on a comparison of the expected future
consumption from working in the modern sector to that from staying in the traditional
sector.4 If the worker remains in the traditional sector, his income will be wT = AT , the
constant productivity parameter. If he decides to work in an entrepreneurial firm in the
modern sector, however, he must first pay a one-time cost to acquire the human capital of
the representative worker in the modern sector. This cost can be thought of as payment for
moving, for direct education costs to acquire the minimum h level for modern work, and for
foregone income during the period of training. For convenience, we assume that there is no
time cost, and that the consumption cost is the same for all traditional workers.5
With growth, the modern-sector workforce is becoming increasingly knowledgeable

so a new migrant will have to acquire more skill than the generations before him. To handle
this, we assume that the migration cost depends on the human capital of the representative
modern worker:
(11) CM = " h # ,
where γ > 1.
!
4 The assumption here is that workers derive utility only from consumption. Urban amenities might also play a
role in this decision, but in order to focus better on the basic mechanism, we ignore this factor.
5 Traditional sector workers consume all of their income. If they migrate, we assume that they borrow the
migration cost and pay it back out of modern-sector wages. Credit constraints are a separate barrier to
structural transformation, but we do not deal with the credit market here.
9
If the following condition holds, workers will leave the traditional sector and migrate
to the modern sector:
) # r & )
(12) * w ( z(t )) h( x ) % " (E ) ( e+r ( x + t) dx + CM (t ) > *w T e+r ( x+t ) dx .
t $ ' t
The right-hand side is the total present-value of consumption from remaining in the
traditional sector. The left-hand side has two terms. The second term is the moving cost,
!
which rises according to (11) as workers in the modern sector accumulate more human
capital. At any time t however, this cost is exogenous to the would-be migrant. The first
term is the discounted integral of total consumption. It is the product of the base wage w
(which the worker at time t takes as given), future human capital that the potential migrant
will accumulate optimally h(x), and the optimal level of work, eW = r/δ (E).
Using (9) to solve for h(x ) , integrating, and using (11) allows us to simplify (12) to:
(13) "( E ) w( z) h > wT + r # h $ ,
where ρ (E) is:

!
& r r
( "(E ) # > 0 if $ ( E ) > r
$(E) [ 2r % $ ( E )]
(
(14) "( E ) = ' ,
( 1 otherwise
(
)
and # "( E ) > 0 . The lefthand side of (13) gives the expected present value of the benefits of
!moving; the righthand side gives the costs. In the case of growth, the ρ (E ) function (14)
and its derivative are both positive because we require that r < " ( E ) < 2r . For there to
! be growth in the first place , the first inequality must be satisfied. The second inequality
insures that the integral in (12) converges when h is growing.
!
We assume that the flow of workers to the urban sector obeys the following:
L˙M
(15) = max [0, " L X ( LM ,h,E )] ,
LM
where θL is a parameter and the X(.) function is derived from (13):

!
10
# ( E ) w( z) h $ r % h &
(16) X ( LM ,h, E ) " $ 1.
wT
When X(.) is positive, the benefits of moving outweigh the costs, and there is a positive flow
of workers to!the urban sector. This flow is proportional to the relative gap between the
modern sector wage (net of moving cost payment) and the traditional wage, where the factor
of proportionality is the parameter θL . Reverse migration is never rational in this model.
That is, if X(.) < 0, then it is not rational for workers to move back to the countryside, since
the migration condition includes the cost of education and relocation. This cost is effectively
sunk and moving back to the traditional sector would not allow a worker to escape any part
of it.
Below, when we simulate the economy, we identify the parameters φ and γ in (11)
with educational policy. Specifically, we think of a low values for both parameters as
reflecting a greater commitment to primary schooling. That is, the lower are φ and γ, the
easier it is for a worker to migrate to the urban area and acquire the necessary education to
take a job with a modern-sector firm.
5 Entrepreneurs, Rent-Seekers, and Policy

Some societies appear to have many more entrepreneurs per capita than others.
Writers like Baumol (1990) would contend that it is not a question of quantity of
entrepreneurs, but rather the nature of the entrepreneurial activity that is being undertaken.
In many societies, according to this argument, talented people with entrepreneurial skill are
better off in unproductive or even destructive activities. Such managers are maximizing their
own incomes but in doing so often hurt the economy, either in terms of levels or rates of
growth (Murphy, Shleifer, and Vishny, 1991). Hirschman (1958) was among the first to
recognize that their existence meant that development could proceed relatively quickly if a
mechanism could be found to call them forth.
Entrepreneurs, we assume, come from a larger managerial class that also includes
“rent seekers”. This second group of managers has sufficient political clout to appropriate
part of the income of the entrepreneurs. They have the ability to divert income from the rest
of society without directly producing anything of value. An individual of the managerial
class faces a choice: he may either remain in the rent-seeking group or become an
11
entrepreneur. If he chooses to become an entrepreneur, he must pay a one-time cost of ε, in

addition to a continuing tax τ that he pays once his firm earns income. 6
The start-up cost ε reflects the costs of capital, of government red tape, and of
education about the law and organizational practice. Nations with good institutions yielding
solid property rights will have a small ε. Recently, Djankov et. al. (2002) have documented
the wide discrepancy in ε (defined to be the cost of setting up a business, in terms of days)
for a large cross-section of countries in 1999. To obtain all the documents necessary to start
a business varies from two days in Canada, three in Finland, and four in the US, to 88 in
Bolivia, 96 in Romania, and 104 in Venezuela. The number of separate procedures, and the
real financial cost are likewise highly variable in the sample.
In many countries, legitimate firms must make significant transfers to others entities,
both public and private, in order to keep operating. Bribes, extortion payments, and
protection money are obvious examples of socially wasteful transfers. Lawyers fees often
reflect useful and legitimate services provided. At other times, however, they represent
payments to settle frivolous suits that would be costly to litigate. Taxes can be payments for
valuable services but some official transfers, like the tobacco settlement payments in the
United States, may be closer to official rent-seeking. We include all such non-productive
transfers in τ.
Let N = E + R be the size of the managerial class, where R refers to the number
of rent-seekers. That is, N is the pool of potential entrepreneurs. Each entrepreneur must pay
a flat tax at the rate τ, so from (5) the net income of a representative entrepreneur now
!
becomes:
(1" # ) y ( z) = (1" # ) (1" $ ) AM z $ .
Rent-seekers would become entrepreneurs if lifetime entrepreneurial income exceeded

transfer income:
!
6 As in the case of migration of workers, we assume that would-be entrepreneurs borrow the funds necessary
to pay the start-up cost, ε.
12
% %
(17) & (1" # ) y ( z(t )) e"r t dt " $ > & s (t ) e "r t
dt ,
0 0
where s is the transfer (subsidy) income received by a rent seeker. If individuals take the
income streams as given to them, and ε is given by policy, then (17) simplifies to:
!
(18) (1" # ) y ( z) > s + r$ .
We assume that the total tax collection τ yE is distributed equally among the R rent seekers
as subsidy income, so that each individual receives:7
!
# E&
(19) s = " y ( z)% ( .
$ R'
We assume that entrepreneurs flow out of the pool of rent-seekers, and that the flow
is greater the larger the discrepancy
! between incomes in the two activities. To be precise, set
(18) to an equality and substitute from (19). The resulting equation defines an equilibrium
distribution of managers between E and R, conditional on z. In turn, z depends on h, LM, and
E via (10). The equilibrium stock of entpreneurs E* is thus a function of h and LM 8 :
(20) E* = E * ( h,LM ) .
We assume that E adjusts adaptively to E* :
(21) ! E˙ = " E [ E * ( h, LM ) # E ] ,
where θE is a parameter. The change in E over time depends on the state variables LM , h,
and E, just like the movement in LM derived above in (15).
!
The parameters ε and τ reflect institutional policy in the simulations below.
7 It is clear from this equation that if τ = 0 then there can be no rent seekers. If we allowed the rent seekers to
appropriate a portion of the traditional-sector income as well, this conclusion would no longer hold. For
simplicity we ignore the possibility that rent-seekers include such landlords.

8 The equilibrium E also depends on N, but since we hold N constant in the simulations we do not put it in
expression (20). Also, note that in general there is no closed form for E* since the δ(E) function in (6) and (10)
may be complex. We handle this in the simulations by lagging E in the expression for z.
13
Reductions in either of these mean that there is a greater commitment to property rights and
bureaucratic efficiency than before.
6 The No-Learning Stationary State

In the no-learning corner the model has a straightforward solution. To illustrate this
case, we assume that h = 1 and that E < Ec , and then solve for the stationary levels of E and
LM . If the value of E from this procedure is, in fact, less than Ec then we have found a
stationary state. The economy will not grow and there will be no migration out of the
traditional sector.
To solve, set X(.) = 0 in (16) with h = ρ (E ) = 1, yielding:
(22) w( z) = wT + r" .
Since the right-hand side is exogenous (wT = AT) expression (22) determines w and then z
via (3). Call this value z*. !
Using (3) and (22), we find that:
$ "AM '*
(23) z* = & ) .
% wT +r# (
The value z* then determines y* = y(z*) in (5). To find the equilibrium value for E, we set
(18) to an equality, then use (19) and the definition of N to eliminate R and get:
!
(24) E * = v ( z*, ", # ) N $ Ec ,
where:
! # y ( z *)
(25) v ( z*, ", # ) = 1$ .
y ( z *) $ r"
Then, from the definition of z when h = 1, we get:
(26) ! LM * = z * E * = z * v ( z *) N .
There are a number of interesting implications from these equilibrium conditions.

First, from (22) we!note that the wage in the modern sector is greater than that of the
14
primitive sector by the constant rφ. The reason is that the cost of migrating — which we
identify with acquiring basic education to achieve h = 1 — is constant at φ. Wages are never
equalized between the modern and traditional sector. There is, of course, evidence that this
has long been the case.9
Second, a decline in the cost φ of acquiring basic education and migrating raises the
stationary human capital intensity z* in (23). This raises both y(z*) and v(z*) thereby
creating more entrepreneurs and migrants by (26). The other educational policy parameter,
γ, has no effect since in the stationary state h = 1. It does have an impact, however, once the
economy begins to grow.
Third, institutional improvements over property rights — which we interpret as

reductions in either ε or τ — have no effect on the human capital intensity z*, so they do not
affect the base wage w(z) or gross entrepreneurial income y(z). They do, however, raise
v(z*) by (25), thereby creating more entrepreneurs out of the managerial class and causing
greater migration to the urban sector. The demand for basic education to acquire h = 1 rises.
7 Generating and Sustaining Growth

Reductions in the policy parameters φ, ε, or τ raise E in the stationary state. If
reduced sufficiently, the economy will leave the no-learning corner and the modern sector
will begin to grow as workers accumulate human capital.10 As h grows, given the policy
parameters, there will be changes in the other state variables, E and LM. The purpose of this
section is to simulate the model in order to shed light on the development process.
7.1 Calibration
Equations (6), (15) and (21) constitute a dynamic system in three variables,
contingent on given values for the total labor force L and the total supply of managers N. In
order to simulate the model, we first need a form for the δ(E) function that enters the human
9 The classic reference is Harris and Todaro (1970).

10 All that is required is that the critical value of E be less than the total number of managers: E < N. The
c
reason is that a τ = 0 is sufficient to eliminate rent-seeking.
15
capital accumulation function (9). We choose a logistic function,11 calibrated such that: (i) δ
(0) = r /10; (ii) the limit of δ as E → ∞ is 2r; and (iii) δ (50) = r. Thus, Ec = 50, so if there
are fewer than 50 entrepreneurs in the economy then there will be no growth in h.
Our initial calibration of the model is made to represent the system in the stationary
state derived above; that is, when there is no growth. We are free to pick arbitrarily a certain
number of the model’s parameters and initial conditions. These are shown in the first
column of Table 1. For example, we assume that the total labor force L is 1000, of which
modern sector workers are initially LM0 = 100. The sum of entrepreneurs and rent-seekers is
N = 100 as well. To ensure that there is no growth, we assume that the initial E = 20 (and
R = 80) so that the initial value v0 in (24) is .20. We pick an initial level of entrepreneurial
income y0 = 100, and a tax rate of τ0 = .5, so that fully half of entrepreneurial income is
appropriated by non-productive rent-seekers. We also set r = .02, β = .5 , and γ0 = 2. We
have already assumed that h0 = 1.
Given the values in Column (1) of Table 1, we are constrained in our choices of the
remaining parameters, which are listed in Column (2) of Table 1. Our choices of τ0 , y0 and
v0, along with (25), determine the initial cost of becoming an entrepreneur ε. Initial human
capital intensity z0 = 5 comes from our choices for initial values of LM , h and E. Initial
entrepreneurial income y0 along with β and z0 determine AM through (5). To determine the
worker migration cost φ0 initially, we assume that the wage in (22) (which from our
assumptions is 20) is split evenly between the traditional sector wage (AT = wT = 10) and the
flow migration cost (rφ = 10).
The policy parameters appear in boldface in Table 1. These are the parameters that
we change to see how the progress of the economy changes.
7.2 Generating Growth
The model is calibrated to begin in the stationary state with no growth.
11 The logistic function has the following form: K

" = , where K, A, and g are parameters that are
1+ Ae# gE
set in the calibration.
!
16
Table 1: Baseline Parameters and Initial Values
(1) Comment or (2) Comment or
Set Definition Implied Definition
L = 1000 Total labor ε 0 = 1875 Fixed cost of becoming

an entrepreneur
LM0 = 100 Modern-sector labor z0 = 5 Human capital

intensity
N = 100 Total Managers AM = 89.44 Productivity in modern

sector
v0 = .20 (E0 = 20) Proportion of AT = 10 Productivity in

entrepreneurs traditional sector
y0 = 100 Entrepreneur income φ 0 = 500 Base migration cost
τ 0 = .50 Tax rate on

entrepreneurs
r = .02 Interest rate
β = .5 Elasticity of labor in
production
γ0 = 2 Exponent in
migration cost
ource: Authors’ calculations.

The surfaces in the two panels of Figure 1 show — from two different angles —the
set of relative parameter values (φ, ε, τ) that establishes E = 50, the minimum number of
entrepreneurs to get growth going. The surface and the points are shown relative to the
baseline values highlighted in Table 1. Thus, Point A in Figure 1 is (1,1,1) and corresponds
to the initial stationary state.
The baseline parameters are repeated in the first row of Panel A of Table 2.
Subsequent rows of Panel A in Table 2 set out the other parameter sets that we consider.
Panel B of Table 2 gives the parameters relative to the baseline values, so that these numbers
correspond exactly to the points shown in Figure 1. The surface in Figure 1 is derived by
E 1
setting the inequality in (24) to an equality, noting that c = , and using (25) for v. This
N 2
yields the following expression:
& )
1 ( ! r$
(27) " = 1# + ,
2 (' y (% ) +*
where the y(φ) function represents (5) with (23) in place of z. All parameter triples below the
surface are sufficient to get growth started. We see from Figure 1 that when τ = 1 (that is, it
!
is at its baseline value of .50) then no combination of φ and ε can get growth going.12
Let us say that the government succeeds in reducing both φ and ε to half of their
baseline values, while τ is temporarily maintained at its baseline level. In Figure 1 this is
represented by Point B, which hovers above the middle of the surface at τ = 1. It is
represented numerically in the second row of each panel of Table 2.
We now turn our attention to Table 3, which shows the state of the economy after 50
years. The first column shows individual human capital h, Column (2) gives the wage of a
modern-sector worker, wh, and Column (3) gives entrepreneurial income, all measured
relative to their initial values at Point A. Columns (4) and (5) show the numbers of
12 This result is, in some sense, an artifact of our calibration. That is, if we set ε to zero in (25) we see that v
goes to 1–τ = .50, so that E can only go to 50, no matter what the value of φ. It does, however, serve to
illustrate that no matter how low we set the fixed cost of becoming an entrepreneur ε, the continuing tax on
entrepreneurial effort τ, might still provide an effective ceiling.
17
Figure 1
Panel A
e 1
0.8
0.6 A
0.4
0.2
0
B
1
C
t 0.8
0.6 D
0.4
1
0.8
0.6
0.4
f 0.2
0
Panel B
f
1
0.8
0.6
0.4
0.2
0
A
B
1
C
0.8
t
D
0.6
0.4
0 0.2
0.4
0.6
0.8
1
e
Table 2
Values of the Parameters Used in the Simulations
Panel A: Values of Parameters for Different Experiments
H1L H2L H3L H4L

Parameters ö f g e t
H1L PtA 500.00 2.00 1875.00 0.50
H2L PtB 250.00 2.00 937.50 0.50
H3L PtC 250.00 2.00 937.50 0.43
H4L PtD 250.00 2.00 937.50 0.32
H5L PtDf 166.70 2.00 937.50 0.32
H8L PtDg 250.00 1.33 937.50 0.32
H6L PtDe 250.00 2.00 625.00 0.32
H7L PtDt 250.00 2.00 937.50 0.21
Panel B: Values of Parameters Relative to Baseline
H1L H2L H3L H4L

Parameters ö f g e t
H1L PtA 1.00 1.00 1.00 1.00
H2L PtB 0.50 1.00 0.50 1.00
H3L PtC 0.50 1.00 0.50 0.86
H4L PtD 0.50 1.00 0.50 0.64
H5L PtDf 0.33 1.00 0.50 0.64
H8L PtDg 0.50 0.67 0.50 0.64
H6L PtDe 0.50 1.00 0.33 0.64
H7L PtDt 0.50 1.00 0.50 0.43
Source: Authors' Calculations.

entrepreneurs and modern-sector workers, respectively, and the last column gives the year in
which the entire labor force is absorbed into the modern sector.
Although at neither A nor B in Figure 1 is there growth — in the sense of

accumulation of human capital — the improvement in both education φ and institutions ε
that are represented in moving from A to B raises the number of entrepreneurs, which brings
migrants into the modern sector to work. The modern-sector workforce more than triples
(Column 5, Table 3). Wages in the modern sector fall to their new stationary state value,
which is 75% of the original value (Column 2, Table 3). This happens because the fall in φ
reduces the cost of moving and new migrants to the city drive down the modern wage until
the wedge between the modern and traditional wages just equals the new value of rφ . The
traditional wage can’t rise since it is fixed by technology.13
Now assume that the government engineers an institutional change that reduces τ
exactly to the surface in Figure 1, which from (27) requires setting τ = .86 (relative to the
baseline). This places the parameter triple at Point C in Figure 1 (values given in Row 3 of
Table 2). Although the number of entrepreneurs rises to E = 50 and the modern-sector labor
force rises to LM = 438 (see Table 3), overall there is not much improvement over Point B.
Unless the institutional reform manages to drive the policy parameter vector below
the surface, living standards will hardly change. To see this, consider Point D in Figure 1,
which corresponds to τ = .64 of the baseline value. Point D lies well below the surface, so
that growth in h will begin. The number of entrepreneurs, human capital, the wage,
entrepreneurial income, and migration all rise strongly over the ensuing 50 years, although
there is not quite enough growth to absorb all of the traditional workers into the modern
sector (Table 3, Row 4). In spite of the 27% increase in h over this time, the wage wh is still
low, just 78% of its initial, pre-migration value at Point A.
7.3 Institutions vs Education
Take the parameter set represented by Point D in Figure 1 and then reduce each of
13 If the marginal product of labor in the traditional sector increased as labor migrated to the city, then the
wage we report in these tables would not decline as much: the wedge would be shared between the sectors.
18
Table 3
Values of Key Variables after 50 Years for Different Parameter Sets
H1L H2L H3L H4L H5L H6L

Variables ö h wh y E LM T
H1L PtA 1.00 1.00 1.00 20.00 100.00 -
H2L PtB 1.00 0.75 1.33 41.68 366.10 -
H3L PtC 1.00 0.75 1.33 49.87 438.10 -
H4L PtD 1.27 0.78 1.63 63.37 912.40 -
H5L PtDf 1.28 0.75 1.71 63.66 1000.00 33.00
H6L PtDg 1.27 0.75 1.70 63.54 1000.00 49.00
H7L PtDe 1.33 0.78 1.70 65.10 1000.00 39.00
H8L PtDt 1.61 1.00 1.62 75.54 1000.00 19.00
Source: Author's Calculations.

the four parameters (φ, γ, ε,τ), one at a time, to 2/3 of their Point-D values. In Figure 1, the
short lines out of D represent three of these changes. The last four rows of Table 2 give the
parameter values; the last four rows of Table 3 show the results of the simulations after 50
years. Reductions in φ and γ are improvements in "education"— they reduce the cost of
migrating and obtaining a primary education — while reductions in ε and τ represent
improvements in "institutions" — they represent reductions in red tape and transfers to
unproductive agents . The parameter γ is irrelevant for getting growth started since h = 1 in
the no-learning corner, and we ignored it above. Now, however, cutting the cost of
becoming educated enough to migrate can occur either by reducing φ or γ in (11). The first
type is immediately important; the second becomes critical later in the growth process, after
h is high.
The results are given in the last four rows of Table 3. We report the results, as
before, 50 years after the policy change.
The results are quite interesting. They show that reducing the tax rate τ is by far the
best policy (Row 8). Such institutional reform dominates educational reform by a long shot.
The last column shows that the traditional sector is completely gone by the 19th year. The
second column shows that the tax reduction policy is the only policy that increases the wage
wh appreciably relative to Point D.
Only with a large stock of entrepreneurs to demand human capital will people find it
worthwhile to accumulate knowledge. Improving education (that is, reducing φ and γ in
Rows 5 and 6) is good at bringing in workers from the countryside, because they need the
elementary education to even begin to hold a job in the city. But if rent-seekers continue to
dominate the managerial class, this will have little long-run impact. The number of
entrepreneurs does not even change (Column 4) relative to Point D: cheaper education,
interestingly, does not increase the stock of productive managers. A 33% fall in γ has almost
no effect on h after 50 years: it is barely higher than it would have been had the parameters
stayed at Point D (Row 6). The result is that the wage wh remains very low, near its
stationary state level.
If a way can be found to reduce τ, significant benefits are likely to follow. By
19
providing a demand for educated workers, people have incentives to acquire knowledge,
causing a substantial increase (27%) in h relative to the Point D policy vector. Real wages
rise by 33%, compared to a slight fall under the education policy. Human capital growth is
so strong that it even offsets the negative effect of migration on w from the initial decline in
φ (that is, in moving the policy parameter vector away from A). In no other case is the
human capital growth strong enough to overturn the decline in w that occurs when the
migration is made less costly. It is the only policy that raises the number of entrepreneurs
appreciably.
8. Extensions
In this section we extend the model in two ways to see if we can realistically boost
the impact from an education policy. First, we consider the possibility that there is a
feedback effect from h to τ. Second, we consider an out-and-out education subsidy to time
spent studying.
8.1 Feedback
We now assume that the tax rate levied on entrepreneurs and distributed to rent
seekers depends on the economy's human capital in the following manner:
(28) " x = " h #$ .
This is a relatively simple way to let the level of development and skill improve the state of
institutions. We keep the values of τ and all other parameters as in Figure 1 and Table 2.
!
Note that until growth begins, this formulation delivers the same results derived above, since
initially h = 1.
The results with the feedback effect are shown in Table 4. We considered three
values for the exponent in (28) — .2 , .5, and 2.0 — but report only the results for the
highest value, ω = 2.0. These are to be compared to the results shown in Table 3. The first
thing we notice is that all policies yield better results than before: there is more human
capital and wages are higher. Wages, especially, are enhanced by the feedback effect. Now,
all of the policies raise h enough that the wage wh gets close to its original level.
Reducing τ is still the best policy, by any of the criteria (Row 8), and in terms of
human capital and real wages of workers, its relative importance is hardly diminished. The
20
Table 4
Values after 50 Years for Different Parameters Sets: Feedback Effect

H1L PtA 1.00 1.00 1.00 20.00 100.00 -
H2L PtB 1.00 0.75 1.33 41.68 366.10 -
H3L PtC 1.00 0.75 1.33 49.87 438.10 -
H4L PtD 1.39 0.95 1.47 77.38 1000.00 33.00
H5L PtDf 1.41 0.96 1.47 77.81 1000.00 28.00
H6L PtDg 1.39 0.95 1.47 77.39 1000.00 33.00
H7L PtDe 1.47 1.01 1.46 80.44 1000.00 29.00
H8L PtDt 1.75 1.20 1.46 89.75 1000.00 19.00
Note: The value of w = 2.0.

Source: Authors' Calculations.
two education reforms (reductions in φ and γ) do raise human capital appreciably more than
before, but still not enough to fully compensate for the fall in w that attends the new
migrants. Institutional reform (reductions in ε and τ) manages to raise wh above the base
level without reducing migration. This is especially true in the case of τ (Row 8, Column 2)
which raises wh more than 20% above the levels achieved with education policy, while
completing the transition in only 19 years (Row 8, Column 6).
8.2 Education Subsidy
Instead of a feedback externality, assume that a portion of the tax levied on

entrepreneurs was given to workers in the modern sector based on how much they study.14
The precise form of the subsidy is:
(29) sh = " w h eL ,
which means that the subsidy per unit of time depends on one's foregone income from
working. That is, if you study an extra hour one day instead of working, you are
!
compensated by σ percent of your hourly wage. In our simulations, we set σ = .10.
The presence of the subsidy changes the first-order conditions and constraints. The
changes are detailed in Appendix B. Note, however, that the subsidy payments paid out to
rent seekers are no longer given by (19). Instead, the education subsidy payments are
subtracted from the tax on entrepreneurs so that rent seekers receive less than before, given
the state of economy:
(30) s R = " y E # $ w h eL LM .
In the simulations below τ and σ are given, so s adjusts to keep the above satisfied as the
stocks of entrepreneurs, human capital, and workers change over time.
!
The results of this exercise after 50 years are shown in Table 5. The first 8 rows of
Table 5 repeat the parameter values of Table 3 (without the feedback effect). The last row
14 Michael Kremer (1993) shows that an education subsidy is optimal in a model where workers of similar
quality are ideally matched in the same firm. If information problems make the match difficult, then a subsidy
to education can improve welfare.
21
Table 5
Values of Variables after 50 Years: Education Subsidy

H1L PtA 1.00 1.00 1.00 20.00 100.00 -
H2L PtB 1.00 0.75 1.33 41.68 366.10 -
H3L PtC 1.05 0.78 1.34 49.89 477.90 -
H4L PtD 1.43 0.86 1.66 63.50 1000.00 31.00
H5L PtDf 1.44 0.86 1.67 63.53 1000.00 25.00
H6L PtDg 1.43 0.86 1.66 63.50 1000.00 30.00
H7L PtDe 1.51 0.91 1.66 65.03 1000.00 25.00
H8L PtDt 1.87 1.19 1.58 75.43 1000.00 16.00
H9L PtDs 1.50 0.91 1.64 63.44 1000.00 28.00
Note: The baseline value of s = .10. In Row (9) the value rises by 1/3.
Source: Authors' Calculations
shows what would happen if we kept the other parameters at their Point D-values (Row 4)
and increased the subsidy by 1/3 over its baseline value of .10.
Again, we note that, relative to Table 3, both h and wh are higher for all of the policy
changes. Moreover, as we note from the last column, all of the policies now result in a
quicker absorption of labor from the traditional sector. This follows from the fact that the
no-learning corner is smaller. With the education subsidy people are willing to begin
learning at lower values of δ (E). Policy-vector C now generates growth; and vector D leads
to a complete transition in only 31 years (before it did not occur within the first 50 years).
Once again, however, it appears that the tax policy is superior (Row 8). That is,
beginning with the parameters at D (see Table 2, Row 4), if you could pick one policy, it
would be to reduce τ. Increasing the education subsidy σ also is effective in raising real
wages compared to Point D, but reducing τ increases human capital and real wages the
most.
8.3 Discussion
We are aware that it is not possible to draw strong conclusions from these
simulations. There are two reasons why our results are at best suggestive. First, the model
does not derive a social optimum, so it is possible for h to grow too fast. Second, the
conclusions about policy changes are dependent on the forms of the utility function and the
structural equations governing taxes, subsidies, migration, and production. Different forms
could diminish or enhance the effect of certain policies.
Our results are suggestive of the pathways to development that may be important,
however, and show that it is possible that entrepreneurs are a key ingredient in that process.
Without a stock of entrepreneurs the demand for education would not be sufficient to elicit
migration and learning, they keys to development and growth. These results, moreover,
provide a theoretical basis for recent empirical research, like Hall and Jones (1999) and
Djankov et al (2002), that supports the hypothesis that institutions are crucial determinants
of differences in living standards around the world. It would be a mistake to ignore
education, however, just because the demand side may presently provide the constraint.
22
9. Empirical Evidence
The model predicts that the demand for education is positively related to the number
of entrepreneurs in the economy. This is the hypothesis that we explore in the remainder of
the paper.
9.1 Data and Econometric Issues
We examine the hypothesis with data from Brazilian states using a panel that runs
from 1996 – 2000. For each of the five years we have data on all 27 states, for a total of 135
observations. 15 We initially run various regressions of the form:
(31) Si t = a0 + a1Ei t + a 2 Xi t + " i + #t + $i t .
Here, Sit is the measure of education demand, Eit is the measure of entrepreneurs, and Xit is
a set of controls
! or conditioning variables. The ai are coefficients that are assumed to be the
same across states. The form includes a state fixed effect νi and a time effect ηt . We will
look at different specifications and use different estimation techniques.
Our dependent variable S is the proportion of 15–17 year-olds in the state with at
least 8 years of schooling. As is evident from Table 6, Panel A, there is considerable
variation in S across states and time periods. Averaged over all five years, in the lowest
state (Alagoas) only 12% of the age group had 8 years or more of schooling, while in the
highest (São Paulo) nearly half (48.8%) had that much education. We chose this measure of
education because it is not likely to be subject to reverse causation.
The main independent variable E is the number of owners and directors of firms as
a per cent of the economically active population. From Table 6, we see that this data also
has some variation, ranging from 2% (Maranhão) to 11% (Rio Grande do Sul), with the bulk
of it being between the states. We do not make any adjustment for the size of these
enterprises nor do we try to separate out firm owners from directors.
15 Our data comes from the IPEA (Institute for Applied Economic Research), a research branch of the
Brazilian Ministry of Planning, Budget, and Management. IPEA collects data from various government
agencies.
23
It is unrealistic to assume that entrepreneurs alone determine youth schooling rates.

We try to account for other channels of causality by adding a set of conditioning variables,
including the average years of education of adults over 25 (Ed25), the Gini Coefficient
(Gini), real per capita spending on education (EdPc), and real per capita spending on health
(HPc). All of these except Gini are expected to enter with a positive sign. These are the X
variables in (31). We also use two variables as potential instruments, the state population
(Pop) and the percent of state spending devoted to administration (Arate).
Three econometric issues are likely to exist with our basic design in (31). In the
remainder of this subsection we give a brief outline of these and then use subsequent
subsections to show how we might deal with each one.
First, our principal independent variable E is likely to be measured with error. That
is, we suspect that Eit = Eit* + eit , where Eit* is the true number of entrepreneurs and eit is a
normally distributed error (we also assume that Cov(Eit*, eit) = 0.) It is doubtful, in other
words, that we have perfectly captured what is special about the stock of entrepreneurs in
raising the demand for schooling. Given the usual assumption on the covariance noted
above, this induces a downward bias in most estimates of the coefficient a1 on E. The
conventional solution to this problem is to find instrumental variables that are correlated
with E* but have no direct effect on S. These are notoriously difficult to find in the growth
literature.
Second, it is likely that the unobserved fixed effect νi is correlated with Eit. If so, the
estimate of the coefficient a1 will suffer from omitted-variable bias (also called
heterogeneity bias). If we think of νi as "good government" or "social infrastructure", which
leads to both higher S (directly) and greater E (indirectly, through the correlation noted
above) then the pooled OLS estimate will have a positive bias. The classical treatment for
this problem is to use a first-difference or a within-group (that is, fixed-effect) estimator.
Third, there is likely to be a dynamic element to our problem. Equation (31) might be
a misspecification. Instead, the true model may contain a lagged value of the dependent
variable S. Including St-1 is reasonable if the process of adjustment in S takes more than one
year. While the dynamic specification creates problems for traditional estimators, it
24
Table 6: Summary Statistics
Panel A: Individual Statistics
Std.
Variable Variation Mean Dev. Min Max
S overall 27.12 11.62 9.21 58.28
between 10.58 12.36 48.86
within 5.14 15.06 39.34
E overall 5.32 2.40 2.10 10.95
between 2.43 2.21 10.63
within 0.22 4.22 5.80
Ed25 overall 5.35 1.11 3.37 8.24
between 1.09 3.62 8.05
within 0.30 4.28 6.88
Gini overall 0.58 0.04 0.44 0.66
between 0.03 0.49 0.62
within 0.02 0.52 0.63
EdPc overall 175.78 113.86 52.17 813.08
between 109.79 69.26 565.57
within 35.64 80.77 423.29
HPc overall 87.25 99.81 4.91 756.09
between 96.67 11.43 496.57
within 29.94 5.71 346.76
Pop overall 6,136.73 7,336.86 285.09 37,100.05
between 7,446.57 305.90 36,047.93
within 182.67 5,086.26 7,188.85
Arate overall 6.26 3.46 1.59 19.74
between 2.84 2.31 12.77
within 2.03 2.93 13.23
Source: Instituto de Pesquisa Economica Aplicada (Institute of Applied

Economic Research, Brazil) 1996-2000.
Table 6: Summary Statistics (cont.)
Panel B: Correlations
S E Ed25 Gini EdPc Invpc Pop Arate
S 1.00
E 0.81 1.00
Ed25 0.76 0.52 1.00
Gini -0.51 -0.34 -0.47 1.00
EdPc 0.39 0.20 0.67 -0.20 1.00
Invpc 0.28 0.24 0.18 -0.10 0.31 1.00
Pop 0.37 0.51 0.16 -0.14 -0.14 -0.02 1.00
Arate -0.22 -0.38 -0.16 -0.12 0.14 0.12 -0.32 1.00
Source: Instituto de Pesquisa Economica Aplicada (Institute of Applied

Economic Research, Brazil) 1996-2000.
generates moment conditions that form the basis of consistent estimators that can be used.
Table 6 gives summary statistics of all of our variables. Panel A shows the mean,
standard deviation, minimum, and maximum, both within groups, between groups, and
overall. Panel B shows the simple correlations between each of the variables.
9.1 Pooled OLS Regressions
To begin, we run a series of pooled OLS regressions that make no allowance for any
of the potential pitfalls noted above. This is done to present a point of comparison for the
different specifications later. Our results are presented in Table 7. The first column shows
the simplest specification: no conditioning variables and no time dummies. The next two
add time dummies and the complete set of controls. The last three drop EdPc and HPc; they
differ in that in columns (5) and (6) we instrument for E with two variables, state population
(Pop) and state government spending on administration as a fraction of state product
(ARate). Recent work by Mulligan and Shleifer (2004) suggests that states with high
population (Pop) have more efficient regulations, since there are economies of scale in
institution building, much like the construction of transport networks and irrigation systems.
On the other hand, we expect that states that spend a relatively high fraction of output on
administration (Arate) might not have institutions favorable to business creation.
Turning to the details of Table 7, we see that E is large and highly significant in all
specifications, although its coefficient falls from about 3.8 to 2.7 when we add the
conditioning variables. Second, looking at Column 3, EdPc and HPc add very little to the
explanatory power of the regression; so we dropped them permanently.16 Adding time
dummies did not have much of an effect on either the magnitude or significance of the other
coefficients in any of the regressions.17 Third, we see that Ed25 and Gini were also both
16 This was true in virtually every specification that we tried. We also used education spending in real terms
(not per capita) and as a fraction of GSP. We never found a significant relationship. Reverse causality may
account for this: states with low enrollment may spend more per person to try to bring these enrollments up.
17 The first-year dummy Year1 was omitted. With the exception of Year2 (which had no influence), the other
dummies were positive and significant. This pattern held in all of the tables.
25
Table 7: Pooled OLS Regressions
Dependent Variable:
S = Per cent of 15-17-Year-olds With At Least 8 Years of Schooling
(1) (2) (3) (4) (5) (6)
3.92 3.83 2.69 2.73 2.75 2.60

E (15.92) (18.44) (15.99) (16.86) (7.44) (5.72)
4.05 3.83 3.78 3.93

Ed25 (7.63) (10.16) (8.32) (6.58)
-36.31 -37.44
-32.37 -38.28
Gini (-2.80) (-3.70)
(- (-
2.67) 2.59)
.005
EdPc (0.81)
-0.009
HPc (-1.14)
Time Dummies No Yes Yes Yes Yes Yes
R2 .65 .75 .89 .89 .89 .89
N 135 135 135 135 135 135
Method OLS OLS OLS OLS IV IV
Notes: Numbers in the parenthesis are t-values, except in the last column,
where they are z-values.
large and significant across all specifications. Finally, when we instrument for E with Pop
and Arate in the last two columns —with error clustering by state in (6) and without it in (5)
— the standard error rises, as expected, but nothing else changes much.18
These regressions do not account for either the possibility of measurement error or
the existence of an endogenous state-level effect νi. To the extent that these problems are
present, the estimated coefficient of a1 in (31) is biased. The direction of the bias is,
however, uncertain even in the univariate case (Xit = 0). In that case, the limiting value of
the estimate (see Hauk and Wacziarg, 2004, Appendix 2) is:
(32)
)
plim a1POLS =
a1
+
(
cov Eit* ,# i ) .
1+
" 2e " E2 * + " e2
" 2E *
Recall that Eit = E*it + eit , where E* is the true value of the fraction of entrepreneurs. The
heterogeneity bias
! stems from the covariance between E* and the state-level effect ν (the
second term) and is positive (we assume the covariance is positive). On the other hand, the
"2
measurement-error bias is reflected in the fraction 2e (the error-to-truth ratio) and is
" E*
negative. It is possible that the two biases offset one another, yielding a total bias that is
relatively low.
!
9.2 Basic Panel Regressions
The panel regressions are shown in Table 8. The first column shows the between-
effects (BE) model and the second shows the random-effects (RE) model. Column (3) shows
the basic within-group (WG) estimates while Column (4) presents the WG model with
instruments for E.
The BE model gives results that are not too different from the earlier OLS
regressions, although the absolute value of the effect of Gini is larger than before. As for the
18 We used a GMM routine to do the IV regressions. The first stage in (5) yielded F values of 15.82 (overall)
and 27.89 (excluded instruments). In the second stage, the Hansen J statistic was .44 (a p-value of .50),
indicating that we cannot reject the joint hypothesis of correct model specification and orthogonal instruments.
26
RE regression, the influences of E and Ed25 are much the same as before, but Gini has a
smaller effect and is no longer significant.
The WG results, however, are completely different. The coefficient on E becomes

essentially zero and the Gini coefficient is significantly positive. A Hausman test between
the results in Columns (3) and (4) confirms that the coefficients are significantly different
(χ2 = 25.33). If no other problems existed, this result would indicate that the WG
specification was superior (that is, that there was a good chance of correlation between the
unobserved component and one or more regressors). Instrumenting for E with Pop and Arate
does not help: as we see in Column (4) even Educ25 loses its significance.
We have two reasons, however, to believe that the fixed-effects results are
misleading.
First, ever since Griliches and Hausman (1986) it has been known that in many cases
the bias introduced by measurement error is larger for the WG estimator than for the other
estimators.19 The BE estimator, especially, attenuates the problem from poor measurement
because it averages the poorly measured E before including it in the regression. The larger
the sample, the closer to zero will be the average error. The WG estimator, on the other
hand, time-demeans the data. This means that it subtracts the “true” part of the variable (i.e.
the average) and leaves the unadulterated noise. So, even though the WG estimator
eliminates the heterogeneity bias, if the measurement-error bias is substantial, the POLS or
BE estimator would be superior.20
This idea was pursued recently by William Hauk and Romain Wacziarg (2004) in the
context of panel growth regressions. They note that for all of the estimators we have
considered it is impossible to work out analytically which performs best in the multivariate
19 Moreover, the Hausman test noted above is not informative when measurement error is present, since
neither the WG nor RE estimator is consistent.

20 The comparison is complicated by the fact that heterogeneity bias in both the POLS and BE estimators is
reduced by the existence of measurement error — this may be seen in the second term in (32) for the POLS
estimator in the univariate case.
27
Table 8: Panel Regressions
Dependent Variable:
S = Per cent of 15-17-Year-Olds With At Least 8 Years of Schooling
(1) (2) (3) (4)
2.70 2.74 -.04 -30.29

E (11.41) (11.37) (-0.03) (-0.71)
3.41 4.27 4.17 -1.13

Ed25 (5.93) (8.18) (3.66) (-0.14)
-66.34 -9.32 29.10 9.40

Gini (-3.76) (-0.77) (1.97) (0.23)
Time
Yes Yes Yes Yes
Dummies
Excluded
- - - Pop, Arate
Instruments
R2 .95 .89 .75 .60
N 27 135 135 135
Method BE RE WG WG-IV
Note: Numbers in parenthesis are t-values, except in the column, where

they are z-values.
setting. Because of this ambiguity, they ran Monte Carlo experiments using a thousand
simulations of the standard growth model, under a variety of assumptions about the
measurement error structure and the nature of the heterogeneity bias. They were then able to
compare their estimated coefficients with the “true” values. Their results showed that the
WG estimator for human capital would often generate negative values for positive
coefficients, at times by factors of -2 (Table 3 in Hauk and Wacziarg). The BE estimator
was generally superior in terms of average absolute bias, and even pooled OLS often
performed better than WG. Our results in Table 8 are consistent with this unstable
behavior.21
But there is another important reason for doubting the fixed-effects results. If the true
model is dynamic, then equation (31) is a misspecification. That is, if S is a function of its
own lagged value St-1 as well as other explanatory variables, then the WG estimator is
known to be potentially substantially biased downward, even in the absence of measurement
error. This bias increases with the degree of persistence in both S and the explanatory
variables (Wooldridge, 2002, p. 302). Panel A of Table 6 reveals that for every variable
there is considerably more between-group variation than within-group variation. This pattern
is consistent with a high degree of persistence over time within each Brazilian state. In the
next section we consider appropriate panel estimators for the dynamic specification.
9.3 Lagged Dependent Variable
Dynamic panel methods, which introduce a lagged dependent variable into the
estimating equation, have become increasingly popular in the growth literature. 22 We now
assume the following structural equation:
(33) Si t = a0 + asSit"1 + aE1 E i t + a X1 Xi t + # i + $t + %i t .
The heterogeneity bias can be eliminated, as always, if we first-difference the equation. This
!
21 They also considered the Arellano-Bond difference estimator (Arellano and Bond, 1991), which we discuss
in the next section.

22 The first paper to use these methods for cross-country growth was Caselli, Esquivel, and Lefort (1996). See
also Levine, Loayza, and Beck (2000), and Easterly and Levine (2001).
28
procedure, however, creates correlation between the new error ( "it # "it#1 ) and the lagged
dependent variable ( yit"1 " y it"2 ). Under the assumption of no serial correlation in the error
term εit and weak exogeneity of the explanatory variables, lagged values of the regressors
!
are valid instruments for the first-differences. The resulting GMM estimator, based on
!
Arellano and Bond (1991), is called the Arellano-Bond difference estimator (ABD). The
ABD estimator is consistent in the presence of both heterogeneity bias and measurement
error bias.
Yet it, too, can be misleading when the sample size is small. If the right-hand side
variables (especially the lagged dependent variable) are highly persistent (and the variance
of νi is large relative to εit ) the instruments will be very weak. In this well-known case the
ABD estimator will have a finite-sample bias in the direction of the WG estimator and be
very imprecise (Blundell, Bond, and Windmeijer , 2000). To illustrate, the ABD estimator
was also computed in the Hauk-Wacziarg simulation exercise and performed as poorly as
the WG estimator.
Instrument weakness and downward bias appear to be relevant for our case. The
ABD result is shown in Column (3) of Table 9. We repeat our earlier results for the Pooled
OLS estimator and the WG estimator in Columns (1) and (2). As anticipated, in Column (3)
there is no evidence that E is significant and its magnitude is similar to the WG estimate.
The Gini has the wrong sign as it does with WG. However, Ed25 retains its significance.
The specification does pass the tests for autocorrelation, denoted m1 and m2 in Table 9.
These tests are based on the assumption that the error εit in (33) is uncorrelated. If true, then
the residuals from the first-differences will demonstrate first-order serial correlation, but not
second-order serial correlation. The results in Column (3) of Table 9 indicate that this
pattern holds.
To improve the precision and reduce the bias inherent in the ABD estimator,
Arellano and Bover (1995) and Blundell and Bond (1998) built upon the ABD estimator to
develop what has come to be called the Arellano-Bond System Estimator (ABS). It
combines the equations in levels with the equations in first-differences, and adds conditions
29
that allow the use of lagged levels to instrument for the first-differences.23 We report the
results of this estimation technique in Column (4) of Table 9. This is our preferred
specification.
The coefficient on Et returns to significance but its magnitude falls from about 2.7
(for POLS and BE) to 1.2. The Ed25 variable continues to be significant (with a smaller
magnitude) but the Gini coefficient loses the significance it had in the POLS. The coefficient
on St-1 is, as we expect, extremely significant. We are encouraged by this equation because it
is consistent with our expectations about the biases from the different estimators. That is, if
(33) is the true specification, then the ABS is the best estimator, and it should lie between
the POLS estimate and the WG (and ABD) estimate. That is just what we see. Moreover, the
tests for autocorrelation — m1 rejecting and m2 accepting the null — point to a correct error
structure for εit (no serial correlation).
9.4 Discussion
The empirical results provide support for our hypothesis – that education depends in
part on the existence of entrepreneurs who demand it– but the relationship is not as strong as
we would have liked to see. The main area of concern is the failure of the fixed-effects
(WG) technique. We have tried to show that there are several reasons to believe that the WG
estimates are not reliable in cases like ours. First, measurement error is likely to inject a
serious downward bias to the coefficients. Hauk and Wacziarg showed that this can be
substantial in their Monte Carlo growth equations.24 Second, the smaller is the within-group
variation relative to the between-groups variation, the worse the relative performance of the
WG estimator. Third, when the true relationship is dynamic, there is a potentially substantial
downward bias from WG methods. The ABS estimator, which is designed to solve these
problems, shows that the proportion of entrepreneurs does have a significantly positive
effect on youth education, although the magnitude of this effect is smaller than that
23 See Bond (2002) and Blundell, Bond, and Windmeijer (2000) for particularly clear explanations of this
technique.
24 We think it is revealing that Barro (1995) did not use fixed-effects (WG) estimation in his study of cross-
country growth.
30
Table 9: Arellano-Bond Estimators
Dependent Variable:
S = Per cent of 15-17-Year-Olds With At Least 8 Years of Schooling
(1) (2) (3) (4)
.26 .47
St-1 - -
(1.88) (4.99)
2.73 -.04 -.20 1.23

E (16.86) (-0.03) (-0.06) (3.03)
3.83 4.17 5.20 3.54

Ed25 (10.16) (3.66) (3.17) (2.99)
-38.28 29.10 63.88 9.03

Gini (-3.70) (-1.97) (2.29) (0.31)
Time
Yes Yes Yes Yes
Dummies
Included
- - Time Dummies Time Dummies
Instruments
-1.82 -2.31
m1 - -
(p = 0.069) (p = 0.021)
-1.17 -1.34
m2 - -
(p = 0.241) (p = 0.188)
N 135 135 108 108
Method POLS WG ABD ABS

Note: Numbers in parenthesis are t-values, except for m1 and m2 (which
are p-values). For ABD and ABS, the t-values are based on small-
sample, robust standard errors. The null for the m-tests is zero
autocorrelation.
estimated by simple pooled least squares.
10 Conclusion
Rich countries have educated populations. But it does not follow that raising the
supply of education is sufficient to create prosperity. The demand for education is also
important. From a policy perspective, in may be best to build institutions to encourage
entrepreneurship at the expense of rent seekers.
We have constructed a model in which workers migrate and choose to become

educated in response to the number of entrepreneurs in the economy and to the costs of
relocation and education. Entrepreneurs arise endogenously; policies to reduce the cost of
business formation can have a major influence on their number in the steady state. The
model was simulated under a number of different assumptions. In every case, a reduction in
the tax burden on entrepreneurs was the best policy for speeding the structural transition.
Education subsidies were helpful, but not as powerful as structural change in this process.
Finally, we presented some empirical evidence from Brazilian states that showed support for
the idea that entrepreneurs were instrumental in raising the educational achievement of
young workers. Our empirical work, like that of Hall and Jones (1999) and Djankov et al
(2002), takes a relatively, short, modern perspective. Institutional quality, however, has also
been shown to matter over the very long run, as the work of Acemoglu et al (2001) and
Shuie and Keller (2004) has recently shown.
Development is complex and the design of policy is difficult. The contribution of

this paper is to show that one key policy — the provision of public education — may be
greatly enhanced by another: institutional reform to help entrepreneurs.
Appendix A: Household Optimization

Individuals are assumed to maximize the integral of discounted utility from the
present to the infinite future, subject to the constraints,
(A1) eW + eL = 1,
!
31
(A2) w h eW = c ,
and the motion equation (17). The current-valued Hamiltonian for this problem is:
(A3) H = Ln c + q!" ( E ) h eL + #1 ( w h eW $ c) + #2 (1$ eW $ eL ) ,
where δ (E) is a general function relating E to learning productivity, q is the shadow price of
individual human capital, and the λi are multipliers.
!
The following conditions are necessary for an equilibrium.
1
(A4) = "1 ,
c
(A5) "1 w h = "2 ,
(A6) ! q " ( E ) h = #2 ,
! #H
(A7) q˙ = r q " = r q " q $ ( E ) eL " %1weW ,
#h
!
(A8) lim q (t ) h (t ) e$r t = 0 .
t "#
!
Define Q = q h. We may restate (A4) – (A6) as:
! 1
(A9) eW = .
Q " (E )
Using (A7) and (17) we may write:

! Q˙ 1
(A10) = r" .
Q Q
And (A8) becomes:
(A11) ! lim Q (t ) e$r t = 0 .

t "#
One way to satisfy the conditions is to set Q˙ = 0 in (A10) which yields Q(t) = 1/r for all t.
Transversality (A11) is satisfied, and (A9) yields:
!
! r
(A12) eW = ,
" (E )
! 32
which is what we set out to show.
Appendix B: Education Subsidy

If individuals receive a subsidy for time spent learning, the constraint (A2) changes
to:
(B1) whew + " h eL = c ,
where σ is the subsidy rate. We assume that the subsidy rate depends on the wage:
!
(B2) " h = "wh ,
where σ is a constant rate. We modify the Hamiltonian (A3) to reflect this new constraint.
There is only one change! from the results in Appendix A. The optimum amount of
work falls for any interest rate. Instead of (A12), ew is now given by:
r $
(B3) ew = # ,
" ( E ) 1# $
provided it is in the interval [0,1]. Learning rises:

! 1 r
(B4) eL = " .
1" # $ ( E )
Subsidy payments only arise if there is actual learning; in the no-learning corner, the
solution is identical to that!in the text. The no-learning corner, however, now exists when the
stock of entrepreneurs is below the value Ecc , defined by the condition:
(B5) " ( Ecc ) = (1# $ )r .
As expected, the threshold for beginning to learn is lower than before. The migration
condition (13) in the text goes through as before, although the ρ(E) term is replaced with:
!
& r % ) r (1$ % )
(B6) "ˆ ( E ) = ( $ + ,
' # ( E ) 1$ % * 2r (1$ % ) $ # ( E )
which reduces to (14) if σ = 0.

!
33
The subsidy payments come out of income that was formerly split between
entrepreneurs and rent-seekers. We assume that the tax rate τ is fixed along with the
education subsidy rate σ, which means that the rate of transfer to rent-seekers s will
generally fluctuate along the growth path. This was also true of the basic model.25
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Institutions, Education, and Development:

The Role of Entrepreneurs

Melayne McInnes, and John Seater for helpful comments.

Entrepreneurs are instrumental for structural transformation. They create and

Entrepreneurs organize and combine factors of production in firms.3 In this paper we

connection between education or human capital and growth.

3 The classic treatment is J. A. Schumpeter (1934).

Our focus is different. We are primarily interested in the structural transformation in

unproductive managers (rent-seekers). If a manager chooses to be an entrepreneur, however,

where AT is an exogenous productivity parameter. Since there is only one factor of

In the modern sector, output is produced by firms organized by entrepreneurs. We do

(6) ! h˙ = " ( E ) heL ,

• Diversity of firms. More entrepreneurs means a greater number of different kinds of

• Opportunities and requirements. It is in the interests of the entrepreneurs to have

considered an important source of knowledge accumulation, although it is not easy to

With growth, the modern-sector workforce is becoming increasingly knowledgeable

(13) "( E ) w( z) h > wT + r # h $ ,

where ρ (E) is:

where θL is a parameter and the X(.) function is derived from (13):

5 Entrepreneurs, Rent-Seekers, and Policy

entrepreneur. If he chooses to become an entrepreneur, he must pay a one-time cost of ε, in

(1" # ) y ( z) = (1" # ) (1" $ ) AM z $ .

Rent-seekers would become entrepreneurs if lifetime entrepreneurial income exceeded

to pay the start-up cost, ε.

We assume that E adjusts adaptively to E* :

simplicity we ignore the possibility that rent-seekers include such landlords.

6 The No-Learning Stationary State

To solve, set X(.) = 0 in (16) with h = ρ (E ) = 1, yielding:

Then, from the definition of z when h = 1, we get:

There are a number of interesting implications from these equilibrium conditions.

Third, institutional improvements over property rights — which we interpret as

7 Generating and Sustaining Growth

9 The classic reference is Harris and Todaro (1970).

reason is that a τ = 0 is sufficient to eliminate rent-seeking.

7.2 Generating Growth

The model is calibrated to begin in the stationary state with no growth.

11 The logistic function has the following form: K

L = 1000 Total labor ε 0 = 1875 Fixed cost of becoming

LM0 = 100 Modern-sector labor z0 = 5 Human capital

N = 100 Total Managers AM = 89.44 Productivity in modern

v0 = .20 (E0 = 20) Proportion of AT = 10 Productivity in

y0 = 100 Entrepreneur income φ 0 = 500 Base migration cost

τ 0 = .50 Tax rate on

r = .02 Interest rate

ource: Authors’ calculations.

entrepreneurial effort τ, might still provide an effective ceiling.

Panel A: Values of Parameters for Different Experiments

H1L H2L H3L H4L

Panel B: Values of Parameters Relative to Baseline

H1L H2L H3L H4L

Source: Authors' Calculations.

Although at neither A nor B in Figure 1 is there growth — in the sense of

7.3 Institutions vs Education

H1L H2L H3L H4L H5L H6L

Source: Author's Calculations.

If a way can be found to reduce τ, significant benefits are likely to follow. By

(28) " x = " h #$ .

H1L H2L H3L H4L H5L H6L

Note: The value of w = 2.0.

8.2 Education Subsidy

Instead of a feedback externality, assume that a portion of the tax levied on

to education can improve welfare.