Occupational choice and the private equity premium puzzle

This paper suggests a resolution to what has come to be known as the 'private equity premium puzzle' (Am. Econom. Rev. 92(4) (2002) 745-778). We interpret occupational choice as a dynamic portfolio choice problem of a life-cycle investor facing a borrowing constraint, stock market participation costs and imperfect information about the profitability of potential businesses. Information is imperfect, because only entrepreneurs observe their own business risk realizations and there is a fixed cost of starting a business. Using numerical techniques we find that the model generates the empirically observed return structure for private and public equity with standard CRRA-preferences and fully rational expectations.