Local governments provide infrastructure improvements, guarantee loans, and offer tax incentives to lure new businesses and keep old ones. This is usually done with one objective in mind—maximizing economic growth. Application of investment portfolio theory to historic data on metropolitan growth rates suggests that there are clear costs to this strategy in the form of increased volatility in growth rates. In addition, most cities are economically inefficient in the sense that the volatility in growth rates is greater than it would be if their economies were better diversified. The extent of this inefficiency, referred to here as avoidable risk, is an effective performance measure for local economic development activities. Local officials should consider this measure and the objective of diversification when making economic development decisions.
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