Protecting Losers: Optimal Diversification, Insurance, and Trade Policy
50 Pages Posted: 10 Jul 2007 Last revised: 19 Jan 2009
Date Written: July 1991
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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