Private Investment and Government Protection

40 Pages Posted: 6 Jul 2006

See all articles by Carolyn Kousky

Carolyn Kousky

Environmental Defense Fund

Erzo F. P. Luttmer

Dartmouth College; National Bureau of Economic Research (NBER); IZA Institute of Labor Economics

Richard J. Zeckhauser

Harvard University - Harvard Kennedy School (HKS); National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: May 2006

Abstract

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. ("Protection" also consists of not imposing threats that raise risk levels, such as draining swamps, or enhance losses, such as building in high-risk areas.) 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's 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. We briefly examine but dismiss the value of rules of thumb, such as building for 1000-year floods or other rules that ignore benefits and costs.

Keywords: Business and Government Policy, Economics - Microeconomics, Environment and Natural Resources

Suggested Citation

Kousky, Carolyn and Luttmer, Erzo F.P. and Zeckhauser, Richard J., Private Investment and Government Protection (May 2006). KSG Working Paper No. RWP06-017, Available at SSRN: https://ssrn.com/abstract=902375 or http://dx.doi.org/10.2139/ssrn.902375

Carolyn Kousky

Environmental Defense Fund ( email )

1875 Connecticut ave
257 Park Avenue South
Washington, DC 20009
United States

Erzo F.P. Luttmer

Dartmouth College ( email )

Department of Economics
Hanover, NH 03755
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
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IZA Institute of Labor Economics

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Germany

Richard J. Zeckhauser (Contact Author)

Harvard University - Harvard Kennedy School (HKS) ( email )

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Cambridge, MA 02138
United States
617-495-1174 (Phone)
617-384-9340 (Fax)

National Bureau of Economic Research (NBER) ( email )

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United States
617-495-1174 (Phone)
617-496-3783 (Fax)

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