The Economics of Natural and Unnatural Disasters

1 - Introduction

1 1 Introduction William Kern Western Michigan University Throughout history mankind has been subject to disasters produced by “Mother Nature” as well as the man-made variety. Only recently, however, have economists understood disasters as economic phenomena to be formally analyzed. Given the magnitude of many recent disasters, their impact on local, regional, and national economies, and the coverage of their consequences in the popular press, it is puzzling that the attention of economists was for so long largely diverted from analysis of these events. Perhaps George Stigler has already provided the answer to this puzzle in his Nobel lecture, where he observed that economists have frequently neglected the study of important current events. He points out, for example, that “during the Industrial Revolution , economists adopted the law of diminishing returns but ignored the most widespread growth of output that the world had yet observed.” The explanation that he offered, perhaps tongue in cheek, was that “the scholars who create economic theory do not read the newspapers regularly or carefully during working hours” (1992, p. 61). We are now observing, happily, a reversal of this practice, as more economists have begun to study the economics of disasters during the past several decades. Although the number of economists who study disasters is still small, the economics of disasters appears to be well on the road to establishing itself as an important subdiscipline in economics. Why are economists now more likely to pay attention to disasters? As Howard C. Kunreuther and Erwann O. Michel-Kerjan report in their chapter, “Market and Government Failure in Insuring and Mitigating Natural Catastrophes: How Long-Term Contracts Can Help,” disasters were, for much of history, regarded as low-probability events. However , they argue that we are now entering “a new era of catastrophes” in which disasters occur with greater frequency and the losses are of 2 Kern a much greater magnitude than in the past. Why are disasters occurring more frequently and why are the losses increasing? Kunreuther and Michel-Kerjan offer several reasons for the greater magnitude and greater frequency of disasters. One prominent change in recent decades is a significant increase in the population concentrated in urban areas on coasts, which puts more people at risk of losses due to hurricanes and tsunamis. The greater level of economic development in coastal areas has also increased the magnitude of losses. Kunreuther and MichelKerjan suggest that global climate change may be at work as well. They point out that of the 20 biggest catastrophes occurring between 1970 and 2004, more than 80 percent were weather-related. Kunreuther and Michel-Kerjan therefore suggest that the time has come to develop a better strategy for coping with disasters. In their opinion, the recent losses suffered in these catastrophic events suggest that inadequate preparation and inadequate mitigation efforts have been the norm. This, they argue, is due in large part to myopia and misperception of the actual risks, both by potential victims and policymakers. What do they suggest should be done? Kunreuther and MichelKerjan offer several guiding principles designed to stimulate greater mitigation efforts and minimize insurance losses while still offering protection against catastrophe. The primary guiding principle is that insurance should be priced in accordance with risk. They argue that such pricing will create incentives to invest in mitigation efforts, citing substantial evidence for the significant benefits of mitigation. Unfortunately , typical property owners will be unlikely to bear the high up-front cost of mitigation efforts in light of the uncertainty of short-run cost savings. Kunreuther and Michel-Kerjan therefore argue for the development of long-term insurance contracts designed to induce property owners to take a long-run view of the problem. However, they recognize that forces on both the supply side and the demand side militate against the emergence of markets for this type of insurance contract. They therefore suggest government action to help create such markets. They argue that the National Flood Insurance Program might offer the best opportunity to create long-term insurance markets and demonstrate the usefulness of long-term insurance policies and thus encourage their development. Introduction 3 While Kunreuther and Michel-Kerjan are able to demonstrate the potential benefits of long-term insurance arrangements, doubt remains regarding the political will to undertake what is necessary to make them viable. As they point out, private long-term insurance contracts have failed to emerge in part because of government policy...