Handling Non-Convexities:

Entrepreneurship and Financial Frictions

Benjamin Moll

1 Model Setup
This note describes a model of entrepreneurship and financial frictions, similar to that in
Buera and Shin (2013) and Cagetti and De Nardi (2006). In particular, occupational choice
in combination with financial friction introduces a non-convexity in individuals optimization
problems. We also introduce a second additional non-convexity, namely a choice between
operating two technologies. Achdou et al. (2014) consider a version with aggregate shocks
and examine its business cycle implications s(here we focus on the model with idiosyncratic
shocks only).

• Individuals’ preferences ˆ ∞
E0 e−ρt u(ct )dt
0

• Workers earn labor income wz θ where θ ≥ 0

• Entrepreneurs choose technology, maximize profits

• Two technologies productive (p) and unproductive (u)

yu = Fu (z, k, `) = zBu k α `β

yp = Fp (z, k, `) = zBp ((k − fk )+ )α ((` − f` )+ )β

– Bp > Bu , but per-period overhead cost fk , f`

– Notation: for any scalar x, x+ = max{x, 0}
– Fp non-concave in k and `
– z: idiosyncratic shock, diffusion process

• Collateral constraints
k ≤ λa, λ ≥ 1.

1
 • Income maximization: occupation and technology choice

M (a, z, A; w, r) = max{wz θ , Πu (a, z, A; w, r), Πp (a, z, A; w, r)}

Πj (a, z, A; w, r) = max Fj (z, A, k, `) − (r + δ)k − w`, j = p, u.

k≤λa

• Individuals solve
ˆ ∞
max E0 e−ρt u(ct )dt s.t.
{ct } 0

dat = [M (at , zt , At ; wt , rt ) + rt at − ct ]dt

dzt = µ(zt )dt + σ(zt )dWt

at ≥ 0

• Optimal capital and labor choices corresponding to the productive technology

(  1−β
 1−α−β β
  1−α−β )
1 α β
kp (a, z; w, r) = min λa, (zABp ) 1−α−β + fk
r+δ w
 1
 1−β
βzABp α
`p (a, z; w, r) = kp (a, z; w, r) 1−β + f`
w

and a similar expression for optimal capital and labor choices corresponding to the
unproductive technology.

• Representative firm
Yc = Fc (A, Kc , Lc ) = ABc Kcη Lc1−η ,

2 Equilibrium Conditions
Individual optimization and evolution of distribution

ρv(a, z, t) = max u(c) + ∂a v(a, z, t)[M (a, z; w(t), r(t)) + r(t)a − c]

c
1 (1)
+ ∂z v(a, z, t)µ(z) + ∂zz v(a, z, t)σ 2 (z) + ∂t v(a, z, t)
2
1
∂t g(a, z, t) = − ∂a [s(a, z, t)g(a, z, t)] − ∂z [µ(z)g(a, z, t)] + ∂zz [σ 2 (z)g(a, z, t)], (2)
2
s(a, z, t) =M (a, z; w(t), r(t)) + r(t)a − c(a, z, t) (3)

2
Public firms

r(t) = ∂K Fc (A, Kc (t), Lc (t)) − δ, w(t) = ∂L Fc (A, Kc (t), Lc (t)) (4)

Capital market clearing:

ˆ
Kc (t)+ ku (a, z; w(t), r(t))1{Πu >max{Πp ,wzθ }} g(a, z, t)dadz
ˆ
+ kp (a, z; w(t), r(t))1{Πp >max{Πu ,wzθ }} g(a, z, t)dadz (5)
ˆ
= ag(a, z, t)dadz

Labor market clearing:

ˆ
Lc (t)+ `u (a, z; w(t), r(t))1{Πu >max{Πp ,wzθ }} g(a, z, t)dadz
ˆ
+ `p (a, z; w(t), r(t))1{Πp >max{Πu ,wzθ }} g(a, z, t)dadz (6)
ˆ
= z θ 1{wzθ >max{Πu ,Πp }} g(a, z, t)dadz

Given initial condition g0 (a, z), the two PDEs (1), (2) together with (3) and the equilibrium
conditions (4), (5) and (6) fully characterize equilibrium.

3 Numerical Solution
The algorithm for solving the HJB equation (1) and the Kolmogorov Forward equation
(2) are nearly identical to that used for solving the Huggett model with a diffusion pro-
cess described in section 5 here http://www.princeton.edu/~moll/HACTproject/HACT_
Numerical_Appendix.pdf. The algorithm is then a simple bisection algorithm on the equi-
librium interest rate.

3.1 Algorithm for Steady State

Use a bisection algorithm for rmin ≤ r ≤ rmax . Given an initial guesses r0 for ` = 0, 1, 2, ...
follow

1. given r` , find ξ` = Kc /Lc from (4)

2. given ξ` find w from (4)

3
 3. given r` and w` , solve the HJB equation

4. find Kc,` from (5)

5. Compute Lc,` = Kc,` /ξ` and compute “excess labor demand”

ˆ
D` =Lc (t) + `u (a, z; w(t), r(t))1{Πu >max{Πp ,wzθ }} g(a, z, t)dadz
ˆ ˆ
+ `p (a, z; w(t), r(t))1{Πp >max{Πu ,wzθ }} g(a, z, t)dadz − z θ 1{wzθ >max{Πu ,Πp }} g(a, z, t)dadz

6. Update r` : if D` > 0, choose r`+1 < r` and vice versa.

4 Results
Figure 1 plots the saving and consumption policy functions. The policy functions can be
non-monotonic. Figure 2 plots the wealth distribution. The wealth distribution has a fat
right tail as in Cagetti and De Nardi (2006).
( a) Saving, wit h Ent r e pr e ne ur s hip ( c ) Cons umpt ion, wit h Ent r e pr e ne ur s hip
7 8
low z low z
6 medium z 7 medium z
high z high z
Cons umpt ion c( a, z )

5
6
Saving s( a, z )

4
5
3

2 4

1 3

0 2
−1
1
−2
0 20 40 60 80 0 20 40 60 80
We alt h, a We alt h, a

Figure 1: Saving and Consumption Policy Functions

References
Achdou, Yves, Jean-Michel Lasry, Pierre-Louis Lions, and Benjamin Moll. 2014.
“Wealth Distribution and the Business Cycle: The Rold of Private Firms.” Princeton
University Working Papers.

Buera, Francisco J., and Yongseok Shin. 2013. “Financial Frictions and the Persistence
of History: A Quantitative Exploration.” Journal of Political Economy, Forthcoming.

4
 ( a) wit h Ent r e pr e ne ur s hip
0.06

0.05

0.04

D e ns ity
0.03

0.02

0.01

0
0 10 20 30 40 50 60 70 80
We alt h, a

Figure 2: Wealth Distribution

Cagetti, Marco, and Mariacristina De Nardi. 2006. “Entrepreneurship, Frictions, and

Wealth.” Journal of Political Economy, 114(5): 835–870.