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Protecting Losers: Optimal Diversification, Insurance, and Trade Policy

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S. Lael Brainard
Abstract

This paper derives a portfolio diversification rationale for a trade policy regime that insures returns to nondiversifiable human capital investment. In the absence of complete insurance markets for human capital, the decentralized equilibrium is characterized by excessive specialization. The socially optimal investment portfolio entails diversification for the reasons familiar from the CAPM. By credibly promising to protect losers ex post, the government can achieve the optimally diversified investment pattern. In contrast to previous results, two instruments are sufficient to achieve both efficient reallocation and full insurance when human capital is mobile at some cost, due to the endogeneity of the initial investment decision.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3773.

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Date of creation: Jul 1991
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Handle: RePEc:nbr:nberwo:3773

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  1. Rothschild, Michael & Stiglitz, Joseph E, 1976. "Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information," The Quarterly Journal of Economics, MIT Press, vol. 90(4), pages 630-49, November.
  2. Grossman, Gene M & Shapiro, Carl, 1982. "A Theory of Factor Mobility," Journal of Political Economy, University of Chicago Press, vol. 90(5), pages 1054-69, October. [Downloadable!] (restricted)
  3. Lawrence F. Katz & Lawrence H. Summers, 1989. "Can Inter-Industry Wage Differentials Justify Strategic Trade Policy?," NBER Working Papers 2739, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  4. Newbery, David M G & Stiglitz, Joseph E, 1984. "Pareto Inferior Trade," Review of Economic Studies, Blackwell Publishing, vol. 51(1), pages 1-12, January. [Downloadable!] (restricted)
  5. Eaton, Jonathan, 1979. "The Allocation of Resources in an Open Economy with Uncertain Terms of Trade," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 20(2), pages 391-403, June. [Downloadable!] (restricted)
  6. Stiglitz, Joseph E, 1981. "Pareto Optimality and Competition," Journal of Finance, American Finance Association, vol. 36(2), pages 235-51, May. [Downloadable!] (restricted)
  7. Eaton, Jonathan & Rosen, Harvey S, 1980. "Taxation, Human Capital, and Uncertainty," American Economic Review, American Economic Association, vol. 70(4), pages 705-15, September. [Downloadable!] (restricted)
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  8. Kenneth L. Judd, 1984. "Efficiency, Adverse Selection, and Production," Discussion Papers 606, Northwestern University, Center for Mathematical Studies in Economics and Management Science. [Downloadable!]
  9. Flemming, John S & Turnovsky, Stephen J & Kemp, Murray C, 1977. "On the Choice of Numeraire and Certainty Price in General Equilibrium Models of Price Uncertainty," Review of Economic Studies, Blackwell Publishing, vol. 44(3), pages 573-83, October. [Downloadable!] (restricted)
  10. Pincus, J J, 1975. "Pressure Groups and the Pattern of Tariffs," Journal of Political Economy, University of Chicago Press, vol. 83(4), pages 757-78, August. [Downloadable!] (restricted)
  11. Turnovsky, Stephen J, 1974. "Technological and Price Uncertainty in a Ricardian Model of International Trade," Review of Economic Studies, Blackwell Publishing, vol. 41(2), pages 201-17, April. [Downloadable!] (restricted)
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