|
Items in cart [0] |
Questions? Call 888-624-8373 |
| Copyright © 2009. National Academy of Sciences. All rights reserved. Terms of Use and Privacy Statement |
Below are the first 10 and last 10 pages of uncorrected machine-read text (when available) of this chapter, followed by the top 30 algorithmically extracted key phrases from the chapter as a whole.
Intended to provide our own search engines and external engines with highly rich, chapter-representative searchable text on the opening pages of each chapter.
Because it is UNCORRECTED material, please consider the following text as a useful but insufficient proxy for the authoritative book pages.
Do not use for reproduction, copying, pasting, or reading; exclusively for search engines.
OCR for page 145
Hazard Compensation and Incentive
Systems:
An Economic Perspective
HOWARD C. KUNREUTHER
Societal problems involving risk and uncertainty pose special challenges
for economics, since standard approaches such as benefit-cost analysis and
market-based mechanisms fall short in dealing with them (Arrow, 1983~.
This paper examines alternative incentive and compensation systems for
dealing with potential hazards from both new and older technologies where
one or more of the relevant stakeholders face a low-probability event with a
potentially catastrophic outcome. The discussion revolves around two broad
areas of current interest:
1. Adopting protective mechanisms: How can individuals be induced to
protect themselves against the potential consequences of hazards, for exam-
ple, by wearing seat belts when in automobiles or by purchasing insurance
against floods or earthquakes? In these cases there are clear benefits to
society in having people protect themselves, although few have voluntarily
done so: fewer than 15 percent of drivers and passengers in automobiles
wear seat belts voluntarily (Arnould and Grabowski, 1981), and few indi-
viduals purchased flood insurance despite its being highly subsidized by the
federalgovernment(Kunreutheret al., 19854.
2. Siting technologicalfacilities: How can an appropriate location for a
new technological plant such as a liquefied natural gas (LNG) terminal or a
hazardous waste facility be determined? These facilities frequently evoke
objections from local people communities usually favor such a facility
only if it is located elsewhere (Popper, 1983~. Can a meaningful compensa-
tion mechanism be designed for sharing the gains of potential winners in
such situations with people in the same situation who perceive themselves as
losing?
145
OCR for page 146
146
HOWARD C. KUNRFUTH~
PROBLEM CHARACTERISTICS
Low-probability, high-consequence events have special features that are
important in designing alternative compensation and incentive mechanisms
for dealing with them. This section discusses five such features: (1) the
nature of risk, (2) the existence of externalities, (3) the need to reconcile
conflicting preferences, (4) ex ante actions and ex post outcomes, and (5)
conflicts between efficiency and equity in designing compensation and
incentive programs. By explicitly considering these characteristics, we may
be able to recognize the opportunities and limitations of proposing certain
courses of action.
The first consideration is the nature of the risk. The phenomena that cause
catastrophic accidents are often "rare" events for which it is difficult to
produce scientifically credible estimates of risk (Weinberg, in this volume).
Catastrophic accidents emanating from an LNG plant or environmental
pollution from a hazardous waste facility are not sufficiently well under-
stood to permit estimates of their probability with any degree of accuracy.
The health and environmental consequences of an accident may not emerge
for years. This latency period between the occurrence of an event and its first
noticeable effects makes it extremely difficult to assign causality to a partic-
ular technological facility (Baram, 1982~. For these reasons there are fre-
quently disagreements among the experts on both the chances and conse-
quences of a particular accident, and there are limited statistical data to settle
these differences. The ambiguities associated with specifying probabilities
and outcomes therefore raise a series of analytical as well as practical chal-
lenges.
Even when extensive historical data are used to determine the nature of a
risk, such as the frequency and severity of motor vehicle accidents, individ-
ual perceptions of risk may- differ from the objective data. Experts and
laypersons alike use heuristics, or rules of thumb, in estimating the probabil-
ities of certain outcomes, and these rules may lead to large and systematic
biases (Slovic et al., 1979~.
A second feature of societal problems involving low-probability, high-
consequence events is that they create externalities situations in which the
actions of one individual affect the welfare of others either positively or
negatively. If a community is willing to accept a hazardous waste facility "in
its backyard," this creates beneficial effects for an entire region. When a
person suffers a severe automobile injury because he or she did not wear a
seat belt, there are negative externalities to the general taxpayer because
health costs are partially subsidized by the government.
These externalities make it difficult to use normal market mechanisms for
dealing with risks. For example, unless there is some type of compensation
OCR for page 147
COMPENS'IOlI AND ECONOMIC lNCENTlVES
147
mechanism associated with the siting of a new technological facility, it is
unlikely that any community will agree to host it. Similarly, if people know
that as victims of a natural disaster they will have their property made whole
by liberal government relief, then there is little incentive for them to protect
themselves with insurance.
A third feature of these societal problems is the many interested parties
who have a stake in the final outcome and want to participate in the decision
process. Each ofthese stakeholders has goals and objectives that effect his or
her preferences. The nature of the risks and the types of externalities associ-
ated with these problems make it difficult for standard market mechanisms
to reconcile conflicting preferences.
Consider, for example, the proposal by a consortium of gas distribution
utilities in 1974 to site a liquefied natural gas facility in one ofthree locations
in California. Over the next three years, a number of interested parties at the
federal, state, and local levels debated the desirability of each of these sites.
By 1977 it became clear that none of them would be approved under existing
procedures. This impasse led the utility companies and business interests to
lobby successfully for a new state siting act. It simplified the licensing
process for LNG facilities and stipulated population-density limits that
would be acceptable to environmental and public interest groups. To help
resolve the safety question, several risk studies were commissioned inde-
pendently by some of the interested parties. The various studies' estimates
of the risk to population differed enough to cause considerable conflict about
whether a proposed facility was "safe enough." Citizen groups sprang up at
the proposed sites and used these studies to voice their concerns about
having a local LNG terminal. Final approval of Point Conception, a site in
an unpopulated area, came at the end of 1982, at which time the utilities
decided to defer construction of the terminal until an unspecified date
(Kunreutheret al., 19831.
A fourth feature of societal problems involving low-probability, high-
consequence events is the ex ante-ex post connection. By ex ante is meant
actions that are taken in anticipation of a disaster and whose purpose is to
mitigate the consequences of a disaster should it occur. For example, a
community might demand some type of payment or compensation for agree-
ing to host a new technological facility. This could be in the form of taxes
paid by the developer or in-kind compensation such as a reduction in resi-
dents' electricity rates. Or, ex ante protective actions might be taken by
industry- for example, designing a facility to reduce the risk of an accident
to an acceptable level. (Buckling one's seat belt is another example of an ex
ante action: it reduces the potential consequences of an automobile acci-
dent.)
By ex post consequences is meant the impact of a disaster or accident on
OCR for page 148
148
HOWARD C. KUNREUTH~
the different stakeholders. Certain actions can be undertaken on an ex ante
basis to deal with ex post consequences directly. The classic example is the
purchase of insurance, which involves paying a premium today in return for
claim payments later. Liability rules that specify who will pay damages after
an accident are another example of ex ante contractual arrangements for
dealing with ex post outcomes. Government relief and compensation for
medical expenses illustrate policy mechanisms that may be instituted only
after a disaster occurs. For example, following tropical storm Agnes in
1972, the federal government passed a special disaster relief bill providing
for $5,000 grants to victims and 1 percent low-interest loans to cover the
. .
remalmng c Damage.
A fifth feature is the tension between considerations of efficiency and
equity in designing meaningful compensation and incentive programs. The
economist has traditionally been concerned with efficiency questions, that
is, with the allocation of resources to improve the well-being of society.
Distributional or equity issues may conflict with this objective when there
are many interested parties each focusing on his or her own welfare or status.
Policy tools such as compensation may be useful in bringing these two goals
closer together, but there are likely to be political and social conflicts that
restrict their actual use.
Kasperson (in this volume) has clearly outlined these conflicts with
respect to the siting of hazardous facilities by developing a set of principles
designed to win public trust. He suggests relying on compensation only after
it has been determined that certain risks are unavoidable. Rather than focus-
ing on unavoidable risks, however, the economist would examine the trade-
off between reducing a given risk and providing sufficient benefits, perhaps
in the form of in-kind compensation, to make the siting acceptable to nearby
residents.
These five features of societal problems involving risks and uncertainty
challenge the analyst and policymaker to develop strategies for making
people aware of the hazards to which they are subject while at the same time
inducing them to make benefit-cost trade-offs. Problems involving the
adoption of protective mechanisms or the siting of new facilities have the
additional complication that individuals must process information or, in
other words, come to understand the significance of probabilities and other
facts relating to low-probability events.
DESIGNING INCENTIVE SYSTEMS FOR PROTECTIVE
ACTIVITIES
Let us now examine the case where individuals are considering whether to
adopt protective actions such as wearing a seat belt or purchasing a car with
an air bag. This action involves some ex ante cost ~ C), which represents
OCR for page 149
COMPENS'ION AND ECONOMIC INCENTIVES
Amok
149
, U (W-C-L')
6k
/~°t,q~
,-`GG~:
P) ~
~cC\~
p
-
':/,~
-
-
FIGURE 1 Decision tree for adoption of a protective activity.
~ U(W-C)
U (W- L)
-
- U (W)
either the additional monetary expense of this safety device or the effort and
discomfort associated with using it. We will assume that the probability of a
disaster is well specified, although potential victims (p) may perceive it
differently than the experts (P) do. The potential loss (L) due to a serious
injury or health effect can be reduced to L' if the individual takes protective
action such as wearing a seat belt or purchasing a car with an air bag.
Traditional economic analysis assumes that individuals are rational, that
they behave as if they are maximizing their expected utility. In the following
example, each potential victim is assumed to have an identical utility func-
tion U and initial wealth W so that their choice about whether to adopt a
protective activity is depicted by the decision tree in Figure 1 .l,2 For the
special case where individuals are risk-neutral, the following simplified
decision rule emerges:
OCR for page 150
150
HOWARD C. KUNREUTHER
P(L-L') ~ C (Adopt)
Otherwise (Do not adopt)
This rule states that protective measures should be adopted if the expected
benefit [P(L-L')] from those measures exceeds the ex ante cost (C).
Rather than actually undertaking some type of benefit-cost comparison as
implied by the expected-utility model, individuals appear to ignore the
negative consequences of an event until after they personally experience an
accident or know someone who has suffered a loss. This behavior can be
characterized by a threshold model where the perceived probability (p) is
below some critical level (p*) . It illustrates two psychological phenomena to
be considered in designing appropriate incentive mechanisms.
First, most people tend to assume that a specific chance event, such as an
automobile accident, will not happen to them. A study by Svenson (1981)
revealed that 80 percent of all drivers believe that they are better than the
average driver. This type of behavior can be understood in terms of the
theory of cognitive dissonance (Festinger, 1957). People prefer not to
acknowledge potential dangers that they believe they cannot avoid, and
hence they either underestimate the chances of such a danger's occurrence
(Akerlof and Dickens, 1982) or assume that the probability of its happening
is so low that it is not worth worrying about (Slovic et al., 1977).
Second, when an accident does occur, there is a tendency to overestimate
the chances of the event's occurring again in the future, a phenomenon
characterized as availability (see Kahneman et al., 1984). People frequently
estimate the chances of an event's occurring in the future by the ease with
which they can imagine it. In addition, the immediacy of a personal experi-
ence can focus attention on the potential for loss in a way that statistical data
may not. Given the difficulties of calling people's attention to potential
hazards, consideration of the several alternative strategies discussed below
. .
1S in orc her.
Broadening the Time Horizon
If individuals treat the probability of an accident as so small that they do
not concern themselves with the consequences, then broadening the relevant
time horizon of hazard information may induce people to protect them-
selves. For example, if residents fail to buy insurance in a 100-year flood-
plain, knowing that the probability of at least one flood during the next 25
years is .22 might induce them to pay attention to the potential consequences
and to avail themselves of protective mechanisms.
People's reluctance to wear seat belts voluntarily might also be due to the
extremely small probability of incurring a fatal accident on a single automo
OCR for page 151
COMPENSATION AND ECONOMIC INCE:ITIVES
151
bile trip (statistical data yield a figure of 1 fatal accident in 3.5 million person
trips). However, demonstrating that this low probability compounds to a
lifetime probability (based on 40,000 trips) of .01 might put the use of seat
belts in a more favorable light. Slovic, Fischhoff, and Lichtenstein (1978)
found in controlled laboratory experiments that most people did in fact
respond more favorably to this lifetime probability than to a trip-by-trip
statement of risk. However, it is not clear whether this way of presenting
information would be effective in modifying people's behavior outside of
the laboratory.
Reducing Insurance Premiums
Another way to induce individuals to recognize the potential benefits of
protective activities is to focus on the immediate returns ex ante from taking
action rather than on the reduction in losses should an accident occur. Insur-
ance rates are a particularly appropriate indicator of what actions are worth-
while economically. In this spirit, Nationwide Insurance Company reduced
its annual insurance premiums by $20 for cars with automatic seat belts.
Nordhaus (1984) estimated that the present-value discounted savings from
the additional expenditure for en automatic seat belt would be $124.00.
It is an open question, however, whether individuals really calculate long-
run savings and compare them with short-run expenditures. Automatic seat
belts normally cost an extra $100 in a car, so the $20 savings in premiums
may look inadequate if consumers think in terms of short-term balance
sheets as Thaler (1983) and Kahneman and Tversky (1984) suggest. If this is
true, then the obvious alternative is for insurance companies to offer large
discounts ($50 to $60) in premiums at the time a car is bought and to reduce
the discounts in subsequent years.
Penalties and Fines
Rather than providing positive incentives for adopting protective mecha-
nisms, penalties can be imposed for those who do not make use of protective
measures. For example, if residents of hazard-prone areas do not buy insur-
ance, they could be held ineligible for federal disaster assistance. On the
other hand, those with at least partial coverage could be permitted to take
advantage of government aid.
With respect to traffic safety problems, Austria has adopted a policy
whereby insurance payments for medical expenses are contingent on the use
of a seat belt, although it may be difficult to determine whether an accident
victim has actually buckled up. This type of conditional ex post compensa-
tion will be successful only to the extent that people believe such a determi
OCR for page 152
153
HOWARD C. KUNREUTH~
nation can actually be made after an accident and hence decide to wear seat
belts.
Rather than linking the penalty to the occurrence of an accident, individ-
uals could be fined for not wearing their seat belts. Under a program recently
adopted in 15 states, a person may be fined up to $50 for failure to wear a seat
belt. More than 30 countries have successfully increased the use of manual
seat belts through this mechanism, with between 50 and 80 percent of
passengers and drivers buckling up (Graham and Henrion, 1984~. The suc-
cess in using penalties to induce protective behavior depends on the individ-
ual's perception of the probability of being stopped and on the magnitude of
the fine. For example, despite Puerto Rico's introduction of a fine in 1974,
seat belt use has not changed appreciably because there has been limited
enforcement.
All of the incentives mentioned above for the adoption of protective
behaviors are designed to force individuals to pay attention to the potential
benefits of taking care. They may be beneficial to society if, as controlled
experimental evidence and field survey data suggest, individuals are poor
processors of information. Not only do people misperceive probabilities,
but they use simplified models of choice that frequently lead them to ignore
the ex post consequences of their "risky" behavior.
COMPENSATION IN SITING TECHNOLOGICAL
FACILITIES
The siting of new technological facilities poses policy challenges that are
different from those of promoting protective activities. The residents of each
potential site are likely to raise questions about the safety of the proposed
facility and to require sufficient ex ante benefits to compensate for the
expected negative impact on their life-styles. For example, even if a waste
disposal site is considered to be acceptably safe, it may create additional
traffic and noise from trucks transporting materials.
There are additional equity arguments for residents demanding some type
of compensation for agreeing to local siting of a hazardous facility. If all the
surrounding towns in the region benefit from the facility, then they should
also be willing to absorb some of the costs. A current problem facing many
urban areas is where to locate a trash disposal facility that will serve the
needs of the region. By maintaining the status quo, the cost of trash disposal
may be considerably higher than if such a facility were established. Hence,
some type of benefit-sharing mechanism may be more efficient and equita-
ble than the status quo if it can be used both to locate a site and to share gains
between winners and losers.
OCR for page 153
COlLIPElYS'ION AND ECONOMIC INCENTIVES
Stages in the Siting Process
153
The negotiation process for choosing the site of a hazardous facility con-
sists of three distinct stages, reflecting the different ways in which the
facility is likely to affect the community. Although each of them is treated
separately below for analytic convenience, the three should be viewed as a
whole when actually selecting a final site.
Stage 1: Building the Facility
Unless taxes and employment benefits are significant, some type of ex
ante compensation arrangement may be necessary to convince a community
that the benefits of a proposed facility are greater than the expected costs.
The word compensation is frequently interpreted by the general public to
mean bribe or payment, particularly when public health and safety are at
stake. Society wants to preserve the belief that life is special; money may
cheapen it, while laying bare the inequality of wealth (Calabresi and Bob-
bitt, 1978~. For this reason, I recommend changing the term compensation
to benefit-sharing, to indicate that interested stakeholders such as the devel-
oper, industry, or other communities who benefit from the facility will
provide either monetary payments or payments in kind to the host commu-
nity. As described below, a number of successful examples of sharing gains
between winners and potential losers suggest that this type of benefit sharing
may be feasible for future siting decisions.
Massachusetts Hazardous Waste Facility Siting Authority Act This leg-
islation, passed in 1975, illustrates the use of monetary compensation for
siting a regional resource recovery facility. The law provided that a royalty
of one dollar per ton would be paid to any community that agreed to host such
a facility. The town of Haverhill, Massachusetts, initially agreed, but in the
face of opposition, the city council withdrew its offer. The town of North
Andover was awarded the site in 1977 after it virtually unanimously
approved the project at a town meeting. By early 1981, several communities
had committed their wastes to the proposed plant (O'Hare et al., 1983) .
Wes-Con, Inc. Wes-Con, Inc., converted two abandoned Titan missile
silos in Idaho into small facilities for the disposal of hazardous materials.
Although there was no public opposition, the developer offered in-kind
compensation in the form of free disposal services, additional fire protec-
tion, and medical training (O'Hare et al., 1983~.
OCR for page 154
154
HOWARD C. KUNREUTHF~
Gray Rocks Power Plant Environmental opposition halted construction
of Gray Rocks Power Plant, a coal-fired plant in Wyoming, because of the
potential damage to the surrounding environment. The suit was settled when
the utility company agreed to set up a $7.5-million trust fund to preserve a
stretch of the Platte River, the habitat of several species of migratory birds
(Lave and Romer, 1983~. The coal plant was completed in 1981 and is fully
operational today.
LNG Facility in Wilhelmshaven The Federal Republic of Germany pro-
vided an additional subsidy for the construction of a recreational facility
because of the adverse affects that a liquefied natural gas plant in Wilhelm-
shaven were expected to have on the tourist industry in the area (Kunreuther
etal., 1983~.
Stage 2: Living With the Site
An important consideration in a community's decision to accept a site is
the impact that the facility will have on future property values and economic
development. Residents may be concerned that the presence of a waste
disposal facility would discourage others from wanting to live in their com-
munity, causing the market price of property to fall and leading to an erosion
of the community's tax base. Willingness on the part of the facility's devel-
oper to compensate residents forced to sell their houses below market value
may allay such economic fears. This arrangement has not been widely
implemented, however. One reason may be the difficulty of determining
what a fair market price would be in the absence of a waste disposal facility.
Regular inspections can be imposed to ensure that a plant is complying
with regulations and specific standards. Before a community embraces a
new technological disposal facility, residents generally want to be assured
that the plant will be forced to meet these regulations or be shut down. The
following examples illustrate this type of monitoring and control arrange-
ment in practice.
Antonell' Corporation The Antonelli Corporation in Providence, Rhode
Island, constructed a facility to treat and store electroplating materials. The
corporation allowed annual monitoring inspections by the citizens and city
officials, and provided additional fire-fighting equipment to deal with any
accident (Sanderson, 1984~.
Wes-Con, Inc. In negotiation with residents, Wes-Con, Inc., the devel-
oper of hazardous materials disposal facilities in Idaho, informally agreed to
shut down the facilities permanently if there was ever a fire.
OCR for page 155
COMPENSATION AND ECONOMIC INCENTIVES
Stage 3: Accidents
155
Communities are naturally concerned about the risk of an accident and its
consequences to residents. There is need for some type of guaranteed ex post
compensation by the developer, the insurance industry, or the government to
cover, at least partially, the accident costs to victims and to act as an incen-
tive for the design of safer facilities. It may be extraordinarily difficult to
look toward traditional insurance arrangements to provide this form of com-
pensation if the risk is not well specified and if there is a long latency period
associated with health consequences (Katzman, 1985~. Today there is great
uncertainty about how future court settlements will assign liability for
accidents the uncertainties involve both the magnitude of awards and their
timing (Huber, in this volume).
In addition, chronic health problems have multiple causes and may be
influenced by genetic and nutritional factors. Hence, it is difficult to deter-
mine whether hazardous substances produce specific effects, and traditional
toxic tort law may fail to provide adequate compensation for these damages
(Trauberman, 19811.
Federal-Private Insurance Some type of federal support for private
insurance programs may be necessary to cover the costs of accidents while at
the same time offering protection to industry from the consequences of
environmental pollution. Specifically, a reinsurance guarantee by the
federal government for losses above a certain magnitude may enable the
private sector to cover the first layer of losses. The Price-Anderson Act (42
U.S.C. 2210Egl), which provides compensation for damages due to the
development or use of nuclear power, authorizes the Nuclear Regulatory
Commission to contract with private insurance companies to make
payment for damages. Similarly, the National Flood Insurance Program
offers some persons in flood-susceptible areas the opportunity to
purchase federally subsidized flood insurance through a joint federal-
private program.
Self-lnsurance Funds If private or government insurance is unavailable,
special types of self-insurance arrangements may be necessary to protect
industry from large losses due to accidents. For example, the chemical
industry may want to administer an insurance fund to pay for specific losses
incurred by parties that store or dispose of waste. This concept may
be attractive, but it has large-scale administrative problems. Some type
of monitoring and control of facilities would be essential in order to
base premiums on risk and to ensure that those participating in the process
OCR for page 156
156
HOWARD C. KUNREUTH~
were not behaving carelessly because they knew they were protected from
losses.
Integrating Stakeholders and Stages
The different interested parties and the three stages of the siting process
can be integrated through a stakeholder-strategy matnx. Table 1 illustrates
the use of the matrix for the hazardous waste siting problem and depicts
which interested parties are likely to be involved in a strategy associated with
a particular stage in the siting process. For example, monetary or in-kind
compensation in Stage 1 should involve the host community, other commu-
nities, the developer, the waste generator, and the state siting authority. As
the matrix shows, the insurance industry will normally be associated only
with Stage 3 of the process.
The conditions necessary for determining which sites are feasible can be
illustrated by constructing a relatively simple decision tree for any given
stage under the assumption that there are n potential candidate sites. Figure 2
depicts the branches of the tree for Stage 1 if there are m different events and
event j has a probability Pij that outcome Cij will occur. An example of a
particular event in Stage 1 is the construction of a new facility that meets all
specifications; another event might be the discovery after the facility is
completed that it is on an earthquake fault. We will assume that there are no
events that will yield any net benefits from the site itself.
For site i to be willing to host the facility, some type of compensation or
benefit (Big must be provided if eventj occurs. If a fixed ex ante compensa
TABLE 1 Stakeholder-Strategy Matrix for Siting a Hazardous Waste
Disposal Facility
Stage ~
Locating the Site
Monetary or
In-Kind
Compensation
Stage 2 Stage 3
Living With the Site Accident
Compensation for
Property Value
Decreases
Insurance
Environmental and Ex Post
Regulation Compensation
Host community
Other communities
Developer
Waste generator
State siting authority
Federal government
agencies (e.g., EPA)
Insurance industry
.
.
.. ~
.
OCR for page 157
COMPENS'IOI!I AND ECONOMIC INCENTIVES
Site 2
-
157
/P1 2
~ C1 1 B1
, C1 2 1
P1 m
-
-
\
:;;~
P
m1
P \
nm ' ~
FIGURE 2 Decision tree for Stage 1 of siting process.
c1 m B.
C21 B2
-
-
~C2m + B2
~ -Cm1 + Bn
~Cmn + Bn
lion package is given to community i no matter what event occurs, then Bid
By for ally. We have adopted this assumption in Figure 2. For Stages 2 and 3,
the amount of compensation will depend on specific events. For example, if
the developer pays residents for decreases in current property values when
they sell their houses, then there will be a probability distribution associated
with anticipated changes in market prices of property in the area.
=
The decision tree in Figure 2 provides a framework for discussing the
issues of risk perception and the elicitation of community preferences. Both
of these issues are important in developing a practicable program for com-
pensation and insurance.
OCR for page 158
158
Perception of Risk
HOWARD C. KUNREUTH~
Controlled experiments on public perception of risk suggest that the costs
Cij associated with eventj at site i will depend on attributes of the associated
risks. Slovic et al. (1980) have analyzed data on individuals' attitudes
toward risky activities ranging from skiing to living near a nuclear power
plant. Two general characteristics appear to define the public's ranking of
the risks associated with these activities: the dread of the risk and whether the
risk is knowable. Technologies perceived as uncontrollable, catastrophic,
involuntary, and highly risky to future generations score high on dread.
Those that are not observable, that are unknown to those exposed, that are
delayed, and that are new are viewed as unknown risks. If a proposed
technology scores high on both risk characteristics, the required amount of
compensation is likely to be extremely high.
A further difficulty in siting new technologies is that the relevant stake-
holders perceive risks differently. Industry and the developer may feel that
the facility does not represent much of a risk because the technology is new
to them and considered controllable, whereas the public may have a different
view. Von Winterfeldt and Edwards (1984) have developed a taxonomy of
technological controversy and investigated the nature of such disputes. They
conclude that controversies about threats that may have catastrophic poten-
tial, such as Love Canal or LNG siting, are frequently due to differing values
among the stakeholders.
A related challenge in siting new technologies is that there is likely to be
considerable ambiguity associated with probabilities of losses. Ambiguity
associated with losses has two principal effects. First, insurance firms have
relatively little interest in marketing coverage for these technologies since
they are unsure of the chances of incurring specific claims. For example, the
insurance industry has opposed providing coverage for losses related to
nuclear power, claiming that the risk is not insurable because of the ambigu-
ity associated with such losses (Hogarth and Kunreuther, 19851. Second, if
there is ambiguity surrounding the probability of specific events, the poten-
tial host community may imagine the potential losses in detail rather than
focusing on the abstract probability. An advantage of employing some type
of benefit-sharing arrangement is that the communities selected as potential
sites are forced to concern themselves with trade-offs between obtaining a
certain payment now or having to incur possible losses in the future with
some unknown probability.
Eliciting Preferences for Communities
An emerging body of literature in economics attempts to answer the
following question: How can one elicit the willingness of an individual or
OCR for page 159
COMPENSATION AND ECONOMIC INCENTIVES
159
community to accept a facility that does potential harm to them but benefits
others? If such a mechanism induces truth telling on the community's part, it
is called incentive-compatible.3
Economists have searched in vain for incentive-compatible mechanisms
that will maximize aggregate net benefits and balance the budget (when the
amount paid by developers and other communities covers the amount
demanded by the host community). Problems of equity and fairness compli-
cate the matter further.4 The institutional arrangements associated with the
siting process add a further dimension to designing appropriate compensa-
tion mechanisms, as illustrated by the Massachusetts Siting Hazardous
Facility Waste Act of 1980. Under this legislation, the developer negotiates
a siting agreement with the host community, offering compensation if neces-
sa~y to satisfy the residents' concerns. Compensation is also provided to
communities likely to be affected by a disposal facility in adjacent districts.
Arbitration is offered to break any deadlocks (O'Hare et al., 19831.
Under this arrangement the developer has an incentive to offer the lowest
possible compensation to the host community as well as to its neighbors, and
the communities have an incentive to demand as large a payment as possible.
If several communities are vying for the facility, some type of auction might
ensure that the community with the lowest bid hosts the facility. Even here,
there is no incentive for a community to tell the truth if it knows that its bid is
likely to be considerably below those of the other possible sites. To date, no
hazardous waste facility has been located under the Siting Act, although the
town of Taunton, Massachusetts, was on the verge of accepting in 1984.
My colleagues and I (Kunreuther et al., 198515 have been investigating an
allocation mechanism whereby each community seeking to host a hazardous
facility submits a bid indicating the compensation it would require to provide
a site for the facility. The community that submits the lowest bid is the
"winner." If there are n candidate sites, then all the other communities would
have to pay 11(n-1) oftheirbid. For example, if there are five communities
that could host a trash facility, each would submit a sealed bid, and those that
were not the lowest bidder would each have to pay a quarter of their bid. This
procedure is guaranteed to yield a budget surplus so that the regional siting
authority would be able to use any funds not given to the host community to
institute improvements benefiting the entire region. Furthermore, the proce-
dure induces communities not to overbid, since their tax will be increased
proportionately if they are not the low bidder. If there are industries associ-
ated with each site, the payments could be made by them rather than using
the tax revenues of the communities. One other theoretical advantage of the
proposed mechanism is the inability of any community to form a coalition
with other candidate sites.
One objection to this allocation mechanism is that the poorest communi-
ties, which already are well endowed with hazardous facilities, will have the
OCR for page 160
160
HOWARD C. KU~REUTHI~R
lowest bids. On equity grounds this is disturbing. There are two ways to
alleviate this problem. The communities that would be potential sites could
be restricted to areas where there are relatively few hazardous facilities. An
alternative approach is to couple this auction procedure with a lottery in
which each candidate has an equal chance of being chosen as a site. Kasper-
son (in this volume) points out that lotteries are frequently used when fair-
ness of selection becomes an overriding requirement, as in the military draft.
In the procedure proposed by Kunreuther et al. (1985), communities that are
not selected by the lottery still have an opportunity to enter a lower bid than
that specified by the one randomly chosen. In this way they can "demand"
that they be chosen as the site. Otherwise they would pay 11(n-1) of their
initial bid.
The Massachusetts Siting Hazardous Facility Waste Act of 1980 reminds
us of the importance of integrating compensation and insurance policies into
a broader framework. More specifically there is a need at the outset to
examine all of the potential sites from both an environmental and an eco-
nomic perspective, eliminating any that do not meet specific health and
safety criteria or that may be inefficient with respect to the transportation of
wastes from industries in the region. Following this step, one must gain an
understanding of the values of the interested parties by determining the costs
and benefits they perceive at each site. At this point conflicts between the
stakeholders will be uncovered and specific benefits and risk-sharing
arrangements, such as compensation and insurance, can be explored. Stan-
dards for design and operation of a facility can be stipulated through appro-
priate monitoring and control procedures by a governmental agency.
CONCLUSIONS
We have examined the features associated with societal problems involv-
ing risk and the cognitive limitations of individuals in collecting and process-
ing information related to low-probability, high-consequence events. Incen-
tive systems and compensation mechanisms may be useful policy tools for
encouraging the adoption of efficient protective activities as well as for
improving the siting process for new technologies. In particular, by intro-
ducing compensation as an option, the public may begin to evaluate its
"willingness to pay" to avoid a net risk in relation to its "willingness to
accept" a given net risk.
The design and implementation of incentive and compensation programs
raise a number of questions regarding the appropriate form, timing, and
magnitude of these payments. The following issues are important in this
regard:
OCR for page 161
COMPE~S~ION AND ECONOMIC INCENTIVES
161
· How do individuals perceive the nature of the risk and the benefit?
· Who is liable for and should therefore bear the cost of an accident?
· What is the default option if a proposed alternative is not adopted?
· What is the perceived role of the public and private sectors in dealing
with accident losses?
· What other policy options could either be combined with or replace
compensation (for example, regulations and standards)?
These questions pose challenges to both the analyst and the policymaker in
educating experts and nonexperts alike. By designing programs that recog-
nize the importance of institutional constraints and individuals' decision
processes, society may be better able to manage low-probability, high-
consequence nsks.
NOTES
A decision tree is a descriptive model of a problem involving a sequence of decisions ( O.
or decision nodes) and chance events (O. or chance nodes). The ultimate outcomes or
payoffs for each possible combination of choice and chance are shown at the tips of the
branches. When outcomes cannot all be expressed in monetary units, the analyst attempts
to quantify the utility (welfare, well-being, or satisfaction) of each outcome. The expected
value of an alternative is a long-run average calculated by multiplying the value of each
possible outcome at a chance node by its probability and then summing these products.
The optimal decision is the one that yields the highest expected value.
2. The same type of analysis could be undertaken by the operator of a technological facility,
who can be viewed as a potential victim (from a financial point of view) should there be an
accident. A decision about whether to increase the safety of a plant by instituting a specific
risk-reduction measure will be determined by comparing the cost (C) with the reduction in
loss (L-L') if an accident with probability P occurs.
3. For a detailed discussion of incentive-compatible mechanisms for this problem, see
Raiffa, 1982, Ch. 22.
4. There is a large body of recent work designed to elicit willingness to pay and willingness to
accept values for public and private goods (see Brookshire et al., 1985, for a summary).
Recently, Keny Smith and coworkers (1985) conducted a survey to determine how
individuals evaluate the expected reduction of risks due to hazardous materials. On the
basis of a field survey in the Boston area, the authors tentatively concluded that one may be
able to elicit households' benefits for reduction of risks due to hazardous materials. If this
preliminary finding is substantiated, then one may be able to compare these estimates with
those obtained by other procedures.
5. The fraction that communities would have to pay could be lower then 1l(n-1) if industry
or the state were partially compensating the community. To prevent overbidding, how-
ever, it is necessary to impose a tax on communities benefiting from the facility.
REFERENCES
Akerlof, G., and W. T. Dickens. 1982. The economic consequences of cognitive dissonance.
Quarterly Journal of Economics 84:488-500.
OCR for page 162
162
HOlYAIRD C. KUNREUTHER
Arnould, R., and H. Grabowski. 1981. Auto safety regulation: An analysis of market failure.
Bell Journal of Economics 12:27-48.
Arrow, K. 1983. Behavior Under Uncertainty and Its Implications for Policy. Institute for
Mathematical Studies in the Social Sciences. Stanford University, Stanford, Calif.
Baram, M. 1982. Alternatives to Regulation. Lexington, Mass.: D. C. Heath.
Brookshire, D. S., D. L. Coursey, and W. D. Schulze. 1985. Experiments in the solicitation of
private and public values: An overview. Paper prepared for the Public Choice Society
Meetings, New Orleans, La.
Calabresi, G. and P. Bobbitt. 1978. Tragic Choices. New York: Norton.
Festinger, L. A. 1957. A Theory of Cognitive Dissonance. Stanford: Stanford University
Press.
Graham, J., and M. Henrion. 1984. A probabilistic analysis of the passive-restraint question.
Risk Analysis 4(1):25-40.
Hogarth, R., and H. Kunreuther. 1985. Ambiguity and insurance decisions. American Eco-
nomic Review: Papers and Proceedings 95:386-390.
Kahneman, D., and A. Tversky. 1984. Choices, values, and frames. American Psychologist
4:341-350.
Kahneman, D., P. Slovic, and A. Tversky. 1984. Judgment Under Uncertainty, Heuristics,
and Biases. Cambridge, England: Cambridge University Press.
Katzman, M. T. 1985. Chemical Catastrophes: Regulating Environmental Risk Through
Pollution Liability Insurance. Homewood, Ill.: Richard D. Irwin, Inc.
Kunreuther, H., J. Linnerooth, J. Lathrop, H. Atz, S. Macgill, C. Mandl, M. Schwarz, and
M. Thompson. 1983. Risk Analysis and Decision Processes: The Siting of Liquefied
Energy Gas Facilities in Four Countries. London: Springer-Verlag.
Kunreuther, H., P. Kleindorfer, P. Knez, and R. Yaksick. 1985. The Role of Compensation for
Siting Hazardous Facilities: Theory and Experimental Design. Working Paper #85-04-03,
Department of Decision Sciences, University of Pennsylvania, Philadelphia.
Lave, L., and T. Romer. 1983. Specifying risk goals: Inherent problems with democratic
institutions. Risk Analysis 3:217-227.
Nordhaus, W. 1984. Supplementing notice of proposed rulemaking on federal motor vehicle
safety standards. Occupant Crash Protection, Docket #74-14, Notice 35, June 13, Refer-
ence 10.
O'Hare, M., L. Bacow, and R. Sanderson. 1983. Facility Siting and Public Opposition. New
York: Van Nostrand-Reinhold.
Popper, F. 1983. LP/HC and LULU's: The political uses of risk analysis in land use planning.
Risk Analysis 3:255-263.
Raiffa, H. 1982. The Art and Science of Negotiation. Cambridge, Mass.: Belknap Press.
Sanderson, D. 1984. Compensation and negotiation primer. Mimeo.
Slovic, P., B. Fischhoff, S. Lichtenstein, B. Corrigan, and B. Combs. 1977. Preference for
insuring against probable small loss: Implications for the theory and practice of insurance.
Journal of Risk and Insurance 44:237-258.
Slovic, P., B. Fischhoff, and S. Lichtenstein. 1978. Accident probabilities and seat belt usage:
A psychological perspective. Accident Analysis and Prevention 10:281-285.
Slovic, P., B. Fischhoff, and S. Lichtenstein. 1979. Rating the risk. Environment 21: 14-38.
Slovic, P., B. Fischhoff, and S. Lichtenstein. 1980. Facts vs. Fears: Understanding Perceived
Risk in Societal Risk Assessment: How Safe Is Safe Enough? R. Schwing and W. Albers,
eds. New York: Plenum.
Smith, K., W. H. Desvousges, A. M. Freeman, III. 1985. Valuing Changes in Hazardous
Waste Risks: A Contingent Valuation Analysis. Draft Interim Report (2 vols.), prepared for
U.S. Environmental Protection Agency.
>
OCR for page 163
COMPENSATION AND ECONOMIC INCENTIVES
163
Svenson, O. 1981. Are we all less risky and more skillful than our fellow drivers are? Acta
Psychologica47: 143-148.
Thaler, R. 1983. Using -mental accounting in theory of consumer behavior. Cornell University
Working Paper.
Trauberman, J. 1981. Compensating victims of toxic substance pollution: An analysis of
existing federal statutes. Harvard Environmental Law Review 5:1-19.
von Winterfeldt, D., and W. Edwards. 1984. Patterns of conflict about risky technologies.
Risk Analysis 4(1):55-68.
OCR for page 164
Representative terms from entire chapter:
seat belts
