Preventing Controversial Catastrophes

Steven D. Baker, Burton Hollifield and Emilio Osambela

No 2015-E35, GSIA Working Papers from Carnegie Mellon University, Tepper School of Business

Abstract: In a market-based democracy, different constituencies will disagree regarding the likelihood and severity of potential economic disasters. Costly public policy initiatives to reduce or eliminate disasters will be assessed relative to alternatives provided by financial markets, where constituencies can trade insurance optimally given the different risks they perceive. In a general equilibrium production economy where two agents disagree about the likelihood of disasters, we define consensus willingness to pay (WTP): the maximum consumption tax rate that both agents would accept to fund a disaster reducing policy. We investigate the level and dynamics of WTP. For example, we show that a policy to eliminate the most severe disasters would be supported at higher cost immediately after a disaster occurs. Policies that eliminate speculative trade entirely typically have higher WTP after a boom. Policies that target uncontroversial tail risk generally have higher WTP than policies that would eliminate sources of disagreement.

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