The trade-off between private diversification and efficiency

After making pretty easy work of Krugman, Waldman argues, “there’s a trade-off between microlevel diversification and macro-efficiency.” He then concludes:

If we want to maintain a well-diversified aggregate portfolio, it may be necessary to restrict the degree to which the portfolio of firms and individuals can be diversified. This implies forcing individuals to bear more risk than they would otherwise choose, in order to reduce systemic risk. We might be better off by letting individuals shed risk via some form of social insurance while forcing investment choices to be sharp, than by encouraging people to blur the information they present in their portfolio choices in order to diversify and hedge.

I’m reading Xiaokai Yang’s textbook on inframarginal analysis. The preface is great and would be worth the trek down to the library. One of the distinctions he makes between management science and economics is business folks care about individual trade-offs and optimal individual choice while economists care about aggregate trade-offs. I agree, of course, but in my experience we spend too much on the former in the economics classroom.

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