Earlier this week, much of Southeast Asia was stunned by an earthquake that for a moment brought back memories of the devastating tsunami of 2004. The cost of such natural disasters has been on the rise in recent years due to an increase in the number of people living and working in high-risk areas. This column explores some of the reasons behind this increase.
It is widely recognised that economic losses due to natural disasters have been increasing exponentially in the last decades. The main drivers of this trend are the increase in population and the growth in wealth per capita. With more and richer people, it is not surprising to find an increase in disaster losses. More surprising is the fact that, in spite of growing investments in risk reduction, the growth in losses has been as fast as economic growth (eg Miller et al 2008), or even faster than economic growth (eg Bouwer et al 2007). Anthropogenic climate change does not seem to play a significant role in these evolutions (Bouwer 2011). In the US, the trend in hurricane losses relative to wealth can be almost completely explained by the fact that people take more and more risks, by moving and investing more and more in at-risk areas (Pielke et al 2008). What are the reasons behind this trend ? This column proposes an alternative to the ‘usual suspects’.
Most of the time, the explanations offered for this increasing risk-taking trend focus on market failures and behavioural biases. There are transaction costs : since the information on natural hazards is not always easily available, households and businesses may decide not to spend the time, money, and effort to collect them (Hogarth and Kunreuther 1995). There are also externalities and moral hazards : since insurance or post-disaster support are often available (especially in developed countries), households and firms do not pay the full cost of the risk, and may take more risk than what is socially optimal (eg Laffont 1995). Irrational behaviours and biased risk perceptions also play a role : individuals defer choosing between ambiguous choices (Tversky and Shafir 1992) ; they have trouble taking into account events that have never occurred before (Tversky and Kahneman 1974) ; and they do not always take long-term consequences into account (Michel-Kerjan 2008, Kunreuther et al 1978).
There is no doubt these factors play a role. But in recent research (Hallegatte 2011), I suggest that this move toward at-risk areas could also be a rational decision – motivated by higher productivity in at-risk areas – rather than a market failure. Investing in risk
My analysis is based on a simple model where investments are assumed to be more productive in flood-prone areas, because there are close to coast and rivers, lowering transportation costs, or because of urbanisation, which leads to concentration and development in river flood plains. Economic agents are then assumed to decide rationally on (i) how much to invest in flood protection ; (ii) how much to invest in flood-prone (protected) areas ; and (iii) how much to invest in safe areas. The main mechanism of the model is really simple : with economic growth, we have more resources to dedicate to disaster protection ; but with better protections, disaster probability is reduced, creating an incentive to increase investment in more-productive risky areas. So when a protection fails or is overtopped by an exceptional events, consequences are larger.