Private Investment and Government Protection

40 Pages Posted: 1 Jun 2006 Last revised: 28 Dec 2022

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.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.

Suggested Citation

Kousky, Carolyn and Luttmer, Erzo F.P. and Zeckhauser, Richard J., Private Investment and Government Protection (May 2006). NBER Working Paper No. w12255, Available at SSRN: https://ssrn.com/abstract=905512

Carolyn Kousky

Environmental Defense Fund ( email )

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Erzo F.P. Luttmer (Contact Author)

Dartmouth College ( email )

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Richard J. Zeckhauser

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

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