Adapting to Rare Disaster Risk
Lessons from Building Codes Raising Death Risk from Earthquakes in Turkey
When I teach Econ 101, I discuss how market competition protects consumers. Consider the restaurant market in Los Angeles. There are many restaurants to choose from. Suppose that Matthew runs one of these restaurants and I underinvest in keeping the kitchen and the food clean. My customers will suffer stomach aches and they will write negative reviews on Yelp and I will quickly suffer from declining demand and my firm may go bankrupt. Note that in this case that there is a tight “cause and effect” relationship chain. I serve low quality food that is cheap for me to make but it causes damage to people’s health and customers use YELP to share this information and I suffer a reputation loss in the medium term for my short run shirking.
If Matthew anticipates this dynamic, he has an incentive to invest in a cleaner kitchen to reduce the probability that he develops a reputation for serving low quality food. No government inspectors or Hygiene Report Cards are needed in this competitive case where “cause and effect” quickly play out.
Before the rise of Yelp, economists such as Phil Leslie and Ginger Jin wrote papers about the benefits of public health report cards in holding restaurants accountable. Do you remember this 2003 QJE paper?
Note my point. Under the competitive assumptions above (including Yelp as an information aggregation website), government is not needed here to punish bad restaurants. Now an interesting free-rider issue arises concerning why people write Yelp reviews. I will not discuss this here.
THIS discussion was a preamble for discussing this recent New York Times piece about housing construction corruption in earthquake prone parts of Turkey. Here is a direct quote;
My read of this case study proceeds as follows. Turkey faces earthquake risk. Home buyers are vaguely aware of this risk but “they know that they do not know “ the exact geography of this risk and they are not fully informed about the abilities of different real estate developers to offset this exogenous risk through good building designs.
The New York Times is telling a corruption story that low quality real estate developers are using bribes to government to purchase government “seals of approval” such that the government building inspectors give the buildings an “A Rating” for offsetting earthquake risk. So, the Times is saying that Turkish home buyers are being tricked by a coalition of developers and corrupt government officials.
This raises several economics issues;
#1 For low probability disasters (such as extreme earthquakes), how does capitalism create incentives for suppliers to produce high quality products? The New York Times is telling a moral hazard story that the buyers naively believe the nice looking structures are safe and don’t ask more questions about risks. The buyer’s trust of government is placing them at even greater risk.
Here is a photo of one of the buildings that was built. It looks nice. How is one supposed to know that it is safe.
#2 Milton Friedman would say that if there are no government building inspectors that home buyers would seek more information about the building before making an investment and moving their families there. How would the home builder establish that the structure faces less risk if a severe disaster occurs? The home builder could bring the experts who advise the project’s construction to meet with buyers. The home builder could promise to pay each home buyer a large $ transfer if a future earthquake destroys the complex. So, posting a bond creates time consistent incentives to build a quality building because the expected cost to the developer of offering this implicit insurance policy equals; probability(horrible earthquake destroys building)*Promised $ Transfer.
The developer can lower this expected cost in the future by building a higher quality building now.
So, the point of this blog post is to highlight two ideas. In capitalism, people are more likely to adapt to emerging low probability risks if they are humble and they “know that they do not know” if they are safe. If they have this self awareness, they will ask more questions and demand more accountability before making a potentially high cost mistake. For profit real estate sellers will devote more effort in producing “safe assets” if they recognize they will lose market share if they invest in a shoddy product. So, note that we have returned to Matthew’s Chinese restaurant example from the start of this post.
For those interested in plays, recall Arthur Miller’s All My Sons. It is the same idea as here. When does capitalism produce shoddy products? They key is to encourage consumers to be the “adult in the room”. Government can often create moral hazard effects here and too little oversight of the asset production process. This leads to lower quality products to be produced and this raises death risk.
In closing this piece, permit me to acknowledge that I recognize that another “solution” here is for government to hire non-corrupt building inspectors who know how to do their job. In developing countries, is this realistic? In the U.S, is this realistic?