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HAZARD COMPENSATION AND INCENTIVE SYSTEMS: AN ECONOMIC 148 PERSPECTIVE original typesetting files. Page breaks are true to the original; line lengths, word breaks, heading styles, and other typesetting-specific formatting, however, cannot be About this PDF file: This new digital representation of the original work has been recomposed from XML files created from the original paper book, not from the retained, and some typographic errors may have been accidentally inserted. Please use the print version of this publication as the authoritative version for attribution. 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 remaining 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 focusing on unavoidable risks, however, the economist would examine the tradeoff 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
HAZARD COMPENSATION AND INCENTIVE SYSTEMS: AN ECONOMIC 149 PERSPECTIVE original typesetting files. Page breaks are true to the original; line lengths, word breaks, heading styles, and other typesetting-specific formatting, however, cannot be About this PDF file: This new digital representation of the original work has been recomposed from XML files created from the original paper book, not from the retained, and some typographic errors may have been accidentally inserted. Please use the print version of this publication as the authoritative version for attribution. 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. Figure 1 Decision tree for adoption of a protective activity. 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 function U and initial wealth W so that their choice about whether to adopt a protective activity is depicted by the decision tree in Figure 1.1,2 For the special case where individuals are risk-neutral, the following simplified decision rule emerges:
