In a recent post, Matthew Kahn stated that “…communities should use their own $ to defend themselves.  Money doesn’t grow on trees and cities face balanced budget conditions.  Do coastal communities merit a subsidy to take gambles?  Read up on moral hazard!  To pay for these subsidies will require that somebody else’s taxes will have to go up.” Basically, should taxpayers pay/provide support for coastal cities’ prevention expenditure?

I’d like to take up on the points that Matthew throws in here. In my opinion, he is right – partly… I think the correct answer to his questions should also really depend on a) the potential for a community to defend itself, and b) on the social benefit that the community creates for society; and on c) the extent to which moral hazard matters. To my great shame I have to admit that I never read his book Climatopolis, but it is somewhere on my desk waiting to be read. So this is here is not a criticism but just some points that he may or may not have already written upon (@Matthew – correct me if I am wrong).

Let us split moral hazard into two classes- ex ante and ex post moral hazard. Honestly, I think that ex post moral hazard cannot be that large a factor. Who really thinks that a financial compensation is able to cover, even partly, the loss of everything that one owns in case the house gets flooded? All the time spent on refurbishing the house, on trying to rescue old photos and getting a harddrive back running that is soaked in water? My guess is that people who move to hazard-prone areas do this because they really feel that the probability of an event is extremely low, or that they can sufficiently shelter themselves from a disaster, or simply and frankly because they have no other choice (e.g. in Bangladesh). I don’t believe that an expected financial compensation in case a disaster occurs makes people feel that this would compensate them sufficiently so that it is worthwhile to move to the hazard-prone area. BUT – this is a guess, and I have yet to see empirical evidence that points in a different direction.

However, ex ante moral hazard is different. It could very well be that someone moves to a hazard-prone area in the belief that once he moved there, society will free resources that then help him to prevent himself from being affected by a disaster. This is a potential problem, and it is different from the case above. Here we deal with ex ante measures to prevent someone from suffering in case a disaster occurs, while above I discussed about the potential extent for moral hazard in an ex post scenario.

Also, some communities do simply not have the finances to shelter themselves against disasters, or not enough money to fully shelter themselves. Should society in this case help that community or not? I think part of the answer depends on whether the moral hazard in the ex ante prevention argument is sufficiently strong or not. If I know that once I moved to a hazard-prone area the government will invest in ex ante prevention, then this will increase my incentives to move there obviously. In this case, society may invest too much into hazard-prone areas, since more people will move there with the expectation of seing an increasing prevention expenditure.

(This could make for a nice simple model btw… Anyone?)

But given the fact that there is no area without hazard, what is society’s optimal level of population in hazard-prone areas?