Private Investment and Government Protection

Carolyn Kousky, Erzo F.P. Luttmer () and Richard Zeckhauser ()

No 12255, NBER Working Papers from National Bureau of Economic Research, Inc

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%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.

JEL-codes: D81 D92 H54 Q54 R10 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-pbe
Date: 2006-05
Note: PE
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Working Paper: Private Investment and Government Protection (2006)
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