This preview shows page 1. Sign up to view the full content.
Unformatted text preview: Private Objectives vs Social Objectives Private Objectives vs Social Objectives
► Do firms minimizing their individual cost of risk achieve optimal risk management from society’s perspective? Firm: minimize COR to the firm Society: minimize COR to society firm plus any additional costs borne outside the firm ► Societal Cost of Risk includes all costs to the Will Firm Choose Socially Optimal Safety Will Firm Choose Socially Optimal Safety
► In the absence of a legal liability or regulatory system, the firm’s MB of safety investment may be lower than society’s MB of safety investment: ► Externality problem: Example: worker bears injury risks and costs ► Unless a firm faces substantial indirect losses and costs of uncertainty, the firm may invest too little in safety (from society’s perspective) Private vs Social COR Private vs Social COR
Total Costs Social COR Private COR Amt of Risk Management Private RM may not lead minimizing social cost of risk RMf RMs Private vs Social RM Objectives Private vs Social RM Objectives
Private MC Social MB Private MB RMf RMs RM Level Societal RM Objectives Societal RM Objectives
Deadweight loss arises from misallocation of RM expenditures Social MB Private MB
Excess injury costs equal to entire Rectangle between RMf and RMs RMf RMs RM Level Can Market Correct Firms’ Incentives? Can Market Correct Firms’ Incentives?
► Market forces may lead to higher indirect costs and costs of uncertainty for a firm if it has a poor safety record ► But what about: Information problems Unequal bargaining power Worker Injury Risk Worker Injury Risk
► Externality problem Worker bears injury risks and costs ► Information problem Worker may be unaware of risks Worker decision making under uncertainty Workers may not be able to quit firm Workers may not be able to demand risk compensation ► Unequal bargaining power (workers and firm) Can Society Correct Firm’s Incentives? Can Society Correct Firm’s Incentives?
► Some kind of external intervention or system is often needed to give correct safety incentives to the party who is able to prevent or reduce a loss ► Tactic: Increase TCOR and thereby increase MB of risk management Can Society Correct Firm’s Incentives? Can Society Correct Firm’s Incentives?
► Moral sanctions (reputation penalties) ► Liability system ► Direct regulation Minimize Society’s TCOR Minimize Society’s TCOR
Firm’s Safety Expenditure $0 $45 $130 $220 $400 $590 $900 Expected Loss to Worker $700 $550 $430 $330 $260 $180 $110 Total Cost of Risk (TCOR) $700 $595 $560 $550 $660 $770 $1010 Prob of Loss 0.070 0.055 0.043 0.033 0.026 0.018 0.011 Socially optimal safety expenditure minimizes TCOR Minimize Firm’s TCOR Minimize Firm’s TCOR
Firm’s Safety Expenditure $0 $45 $130 $220 $400 $590 $900 Expected Loss to FIRM Total Cost of Risk (TCOR) Prob of Loss 0.070 0.055 0.043 0.033 0.026 0.018 0.011 Societal (Government) Actions to Affect Societal (Government) Actions to Affect MB of Risk Management
Private MC Social MB Private MB RMf RMs RM Level U.S. Government Risk Management U.S. Government Risk Management
► There is a recognition that markets for risk are highly imperfect Strong willingness of government to intervene To promote: ►Economic growth (business protection) ►Worker protection ►Consumer/individual protection Government Risk Management Government
► Government has several advantages as a risk Government manager: manager: Can mandate program participation or Can insurance purchase insurance Can alter institutional rules Has much stronger enforcement powers Can tax and print money Can spread risk or costs across generations Workers’ Compensation System Workers’ Compensation System
Mandatory participation Worker risk perceptions and lack of bargaining power Absolute employer liability and state benefits Is intended to make employer liable for all on the job injuries Assure that workers get fair compensation Exclusive remedy Reduce burden on employers Reduce disputes and transactions costs Speed up compensation Workplace Safety Regulation Workplace Safety Regulation
► Workers compensation system removes threat of tort liability which dampens employers safety incentives Regulation provides direct incentives for safety Information for employers and employees ► Regulation sets systemwide standards Liability System Liability System
► More generally, the liability system defines More a specific way of redistributing risk of accident losses accident ► Efficient risk bearing: Assign liability (payment responsibility) to the Assign party most able to bear losses party Assign liability (payment responsibility) to the Assign party most able to prevent losses party Economic Role of Liability System Economic Role of Liability System
• Optimal risk bearing and compensation
• Provide a form of insurance coverage to individuals who face risk of losses caused (inadvertently) by others • Safety objectives
• Provide incentives to individuals or organizations to engage in loss control Minimizing Social Cost of Risk Minimizing Social Cost of Risk
► Estimate the effects of risk management on E(losses) + residual uncertainty. ► Find each individual’s benefit (cost) from the risk management ► Sum benefits and costs across individuals. ► If this sum exceeds the cost of risk management then undertaking risk management will increase social wellbeing. Otherwise it will not. Societal COR = Σi[Cost of Riski ] Minimizing Social Cost of Risk Minimizing Social Cost of Risk
► Example 3 person society (Me, U, It) 2 risk management alternatives (A, B) TCOR: Me TCOR: U TCOR: It RM A RM B $100 $0 $100 $50 $100 $200 Maximizing Social “Welfare” Maximizing Social “Welfare”
► Minimizing social cost of risk is an economic efficiency notion ► It does not take into account distributional effects ► Societies are generally concerned about both distributional issues and efficiency As a society we are generally willing to accept some reduction in efficiency in order to achieve social priorities Difficulties in Societal Risk Management Difficulties in Societal Risk Management
► Defining social priorities Risk tradeoffs across individuals ► Measuring cost of risk to individuals E(L) Uncertainty costs ► value of life or health ► vary with risk aversion ► public perceptions of risk difficult to measure ...
View Full Document
- Spring '07