Trade-related job loss, wage insurance and externalities: An ex ante efficiency rationale for wage insurance

Abstract

The extension of adjustment assistance to those who have suffered trade-related job displacement is widely supported on both sides of the economics of globalisation debate. The form that such assistance should take, namely wage insurance, is also the subject of wide agreement. Nevertheless, the formal economic rationales offered for such a policy are varied, including political economy arguments, equity arguments and market failure/ex post efficiency arguments. This note proposes an ex ante efficiency-based rationale for the provision of adjustment assistance in the specific form of wage insurance. Job displacement imposes pecuniary externalities on displaced workers, which, in a complete markets setting, induce only shifts along the ex ante Pareto-efficient frontier. However, when markets are incomplete, pecuniary externalities become welfare-relevant. Without the possibility of diversifying or hedging the risk of pecuniary external diseconomies of job displacement using contingent claims, welfare is reduced ex ante Wage insurance - whether publicly underwritten, privately underwritten. (as in Shiller's (2003) 'livelihood insurance'), or supplied on a mixed public/private basis - completes the market for contingent claims, allowing workers to diversify or hedge the risk of trade-related pecuniary external diseconomies. By facilitating risk sharing, wage insurance removes an impediment to ex ante Pareto efficiency. Moreover, wage insurance affects not only post-displacement behaviour by increasing the incentive to reacquire employment quickly, but it also affects pre-displacement consumption and investment behaviour, in particular, lowering the threshold at which workers will be willing to undertake irreversible investment in industry-specific skills. © 2007 The Author Journal compilation © 2007 Blackwell Publishing Ltd.