Abstract
In this paper we argue that the appropriate concept of regional economic efficiency is Baumol’s lower confidence limit criteria. This implies a substantially reduced subset of the usual Markowitz efficient frontier. We examine this proposition in the context of a tractable equilibrium model with a data set for the province of Saskatchewan. We conclude that the Baumol efficiency criteria suggest maintaining substantial levels of activity in the high-risk, but higher-return, resource sectors of the economy. The results suggest that the cost of stability could be high, in terms of per capita income, if this economy were to diversify too far from its resource-based comparative advantage.
Highlights
INTRODUCTIONThe purposes of this paper are to discuss the relationship between regional risk (instability) and regional efficiency, and to consider the implications for diversification policy for a small open resource-based economy when the risk measure used is the Baumol (1963) "Likely Lower Bound" measure rather than the usual portfolio variance measure
The purposes of this paper are to discuss the relationship between regional risk and regional efficiency, and to consider the implications for diversification policy for a small open resource-based economy when the risk measure used is the Baumol (1963) "Likely Lower Bound" measure rather than the usual portfolio variance measure.Regional efficiency is defined in terms of the trade-off between regional return and the regional risk measure
We argue that the relevant concept of regional efficiency is a substantially reduced subset of the Markowitz frontier that results from a semi-variance notion of risk
Summary
The purposes of this paper are to discuss the relationship between regional risk (instability) and regional efficiency, and to consider the implications for diversification policy for a small open resource-based economy when the risk measure used is the Baumol (1963) "Likely Lower Bound" measure rather than the usual portfolio variance measure. The Markowitz (1959) concept of efficiency and certainly the minimum variance approach of Lande (1994) and Malizia and Ke (1993) contain many portfolios that would be considered inefficient using the criteria that Baumol (1963) suggests. The quadratic utility function has the undesirable property of implying increasing absolute, and relative, risk aversion. This in turn implies that a risky investment is an inferior good (see Arrow 1963 and Pratt 1964).
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