Thursday, 12 November 2015

Cost-benefit analysis of averting catastrophes just got a whole lot harder

I'm a bit late to this, given it has already been covered by Tyler Cowen and then by Eric Crampton. However, now that I've read the paper in the American Economic Review (ungated earlier version here) by Ian Martin (London School of Economics) and Robert Pindyck (MIT), I feel I can comment on it.

In the paper, the authors develop a mathematical theory of the costs and benefits of averting (or reducing the impact of) catastrophes (like viral epidemics, Nuclear or bioterrorism, climate change catastrophes, etc.). The core (and somewhat worrying) takeaway from the paper overall is that, in the presence of multiple potential catastrophes, a simple cost-benefit rule doesn't work:
Conventional cost-benefit analysis can be applied directly to “marginal” projects, i.e., projects whose costs and benefits have no significant impact on the overall economy. But policies or projects to avert major catastrophes are not marginal; their costs and benefits can alter society’s aggregate consumption, and that is why they cannot be studied in isolation...
When the projects are very small relative to the economy, and if there are not too many of them, the conventional cost-benefit intuition prevails: if the projects are not mutually exclusive, we should implement any project whose benefit wi exceeds its cost τi. This intuition might apply, for example, for the construction of a dam to avert flooding in some area. Things are more interesting when projects are large relative to the economy, as might be the case for the global catastrophes mentioned above, or if they are small but large in number (so their aggregate influence is large). Large projects change total consumption and marginal utility, causing the usual intuition to break down: there is an essential interdependence among the projects that must be taken into account when formulating policy.
The implications of this are pretty broad, including:

  • The value (to society) of averting a catastrophe depends on what other catastrophes are being averted;
  • It may be optimal not to avert some catastophes, even when averting those catastrophes might seem justified based on a naive cost-benefit evaluation;
  • Deciding which catastrophe is the most serious and prioritising averting that one is not the optimal approach; and
  • These results hold if there are many small catastrophes, as well as when there are fewer (but more serious) ones.
The authors conclude:
We have shown that if society faces more than just one catastrophe (which it surely does), conventional cost-benefit analysis breaks down; if applied to each catastrophe in isolation, it can lead to policies that are far from optimal. The reason is that the costs and benefits of averting a catastrophe are not marginal, in that they have significant impacts on total consumption. This creates an interdependence among the projects that must be taken into account when formulating policy.
All of which means that, because of the interdependence between these catastrophes (even if they are many and small), cost-benefit analyses of things like mitigating earthquake or tsunami risk just got a whole lot harder to do in a robust way.

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