Private Investment and Government Protection
Resources for the Future
Erzo F. P. Luttmer
Dartmouth College; National Bureau of Economic Research (NBER); Institute for the Study of Labor (IZA)
Richard J. Zeckhauser
Harvard University - Harvard Kennedy School (HKS); National Bureau of Economic Research (NBER)
NBER Working Paper No. w12255
Hurricane Katrina did massive damage because New Orleans and the Gulf Coast were not appropriately protected. Wherever natural disasters threaten, the government -- in its traditional role as public goods provider -- must decide what level of protection to provide to an area. It does so by purchasing protective capital, such as levees for a low-lying city.We show that if private capital is more likely to locate in better-protected areas, then the marginal social value of protection will increase with the level of protection provided. That is, the benefit function is convex, contrary to the normal assumption of concavity. When the government protects and the private sector invests, due to the ill-behaved nature of the benefit function, there may be multiple Nash equilibria. Policy makers must compare them, rather than merely follow local optimality conditions, to find the equilibrium offering the highest social welfare.There is usually considerable uncertainty about the amount of investment that will accompany any level of protection, further complicating the government%u2019s choice problem. We show that when deciding on the current level of protection, the government must take account of the option value of increasing the level of protection in the future.
Number of Pages in PDF File: 40working papers series
Date posted: June 1, 2006
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