Tuesday, November 13, 2012

"Hard" and "Soft" Investments to Protect Against the Next Storm Called Sandy

The WSJ previews some different investment options for coastal cities in the face of natural disaster risk.  Note the search for solutions!  Don't forget Julian Simon's optimism that a larger population offers more possible good ideas.   Note the debate between the "hard" engineers who advocate investments in Sea Walls and the naturalists who advocate land set asides for wetlands and other "soft" investments.   Who is right? How will these possible solutions be vetted?

From the perspective of intermediate micro, we need to know what is the marginal productivity of each of these investments in terms of reducing storm risk and what is the price tag on each of these proposed solutions? With this information, one can calculate "bang per buck" and rank these projects.  If there are synergies between these projects then this will add complications but this is the rational approach to playing defense.  Now, the interesting issue is how to finance these investments.  

In typical intermediate micro, we know the production function (because the professor assumed it).   For example, a typical pizza production would be;  pizza = 40*square root of Labor.  So, if a firm hires 100 laborers, it produces 400 pizza.    Note the certainty in this case.  We understand this production function and there are no shocks and no "fat tail" risk.  (i.e there is zero probability that you hire 100 workers and end up with 0 pizza produced).

But, in the case of providing safety for Manhattan what is the analogous "production function"?  Hansen and Sargent's work on robustness is relevant here because we don't know really know what will be the shocks that take place in the future and how well the proposed solutions (the hard vs. the soft) can handle such shocks.  In evaluating the "hard" versus "soft" safety investments, are either set more robust in the face of fat tail risk?

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