Thursday, May 13, 2010

Moral Hazard, Liability and Oil Spills

At the end of my junior year at UNCW, the Exxon Valdez ran aground in Prince William Sound, Alaska. The biological and economic damage was nothing short of catastrophic. 20 years later... here we go again.

It's a stretch to say that anything good comes of disasters like these, but Valdez gave us the Oil Pollution Act (OPA), and considerably tighter standards on shipping. Valdez also greatly accelerated the use of non-market valuation methods, especially contingent valuation (CVM), advancing the science and practice of economic valuation at speeds that would have not occurred otherwise. We'll study CVM in lecture 4. You can read about some of the value estimates here at the Encyclopedia of Earth entry for the spill (scroll down to the section on "economic impacts").

The Gulf Coast spill should have similar legal repercussions. Of particular interest is the legal cap on liability. OPA limits liability to $75 million, which was a lot of money in 1990, but seems far too low today. The White House is already pushing for the cap to be removed, but as good students of economics, we have to ask if things might have been different had the cap been changed earlier.

The topic here is "moral hazard" and it's one that has been in the news a lot lately (bank bailouts). Basically, if you have really good insurance (coverage against loss), you're more likely to engage in risky behavior. In the context of the Gulf Spill, if the responsible party were liable for 100% of the damages (with no maximum), would they have taken more caution than if their liability were limited?

Here's a long quote that addresses the point:

"If the consequences of one's actions are felt only by one's self, one will take optimal precautions to avoid accidents. Economists predict that a rational person will invest in accident avoidance just enough resources so that the marginal cost of accident avoidance equals the marginal benefit of accident avoidance. This minimizes the total of the two costs: the cost of accidents plus the cost of precautions.

In the case of accidents that affect others, the individual's incentive to take precautions is not optimal, unless the liability system acts to "internalize" the costs of accidents. Various liability rules (such as strict liability, negligence, and no fault) affect people's incentives to take economically appropriate precautions. If people know that they can be held responsible for some or all of the costs or damages sustained in an accident, they will change their behavior to make the accident less likely to occur or to reduce the damages should it occur.

Some liability systems produce too much precaution; others produce too little. An excessively cautious individual may reduce the chances of an accident to zero by staying home in bed all day, but the cost in lost income would be very high. Similarly, a liability system that yields too much precaution may lead manufacturers to produce the only perfectly safe airplane--one that never leaves the ground.

Conversely, if the liability system did not allow people involved in automobile accidents to sue the responsible party for damages, drivers would have less incentive to be careful. The actions people take every day indicate that individuals and society accept the riskiness of some activities. Eliminating all risks, if possible, would be overly cautious.

Any liability system that seeks to optimize the trade-off between the costs of accidents and the costs of preventing them must take into account, among other things, all the costs associated with accidents. If some important category of costs is ignored by the system, individuals will tend to take too little precautionary action. By the same token, if the system exaggerates the costs, there will be a tendency to take too much precaution"

It is interesting to note that this was written in 1995, in a book titled: "The Economics of a Disaster: The Exxon Valdez Oil Spill" by Argue, Furchtgott-Roth, Hurdle, Mosteller, and Owen.

Seems pretty timely now too.

Thoughts or questions?

Applying basic supply and demand modeling, what kinds of effects do you think we'll see in the wake of the Gulf spill?


Wanda Lewis said...

I find this article very interesting, especially the quote. If the cap on liability is replaced with an extremely higher amount, oil companies will then begin to take alot more precautions. While it is obvious more precautions are needed at the moment, too many precautions may be exagerated. Just like in the quote, some people may take way too many precautions to avoid an accident. If oil companies decided to spend more on taking precautions this will all come down to the basic model of supply and demand. If it costs more for them to be in the oil business, then their costs to produce oil will go up. Therefore their prices will increase. When prices go up, demand will go down. Individuals will look for alternatives to using so much gas, such as carpooling or walking more.

Peter Salyga said...

I would like to disagree with the quote. I do not see precautionary reactions going off to such an extreme with the concept of no liability insurance. Instead I would rather like to think increases in precautions will spawn innovation, safer methods, and tremendous cost savings. For example if car liability insurance were to be whipped out today, 95% of people would drive as little as possible. Accidental wrecks could end up costing hundreds of thousands of dollars for an individual, but they would also decrease tremendously due to less people filling the roads purposelessly. If an alternate method exists it may actually be used and innovated further – trains, buses, safer cars, and all forms of mass transportation. However the rate we see innovation is these areas is a light year shy of what we see in cars [a new model is revealed every 2-4 years.] Obviously there is a much higher demand for cars, but is it because we actually want these cars or because a liability insurance system exists that keeps this demand affirmed and actually halts innovation from greater ideas?

Well in my opinion, liability (cap) insurance not only presents a moral hazard, but also halts new innovation. It hides the actual costs that are associated with current technology. If individuals/corporations where actually responsible for their accidents and bear the full costs, demand would obviously drop for the method in use and open a door for new ideas. A substitute idea/innovation would soon rise and slowly gain traction until it is exhausted and needs to be further innovated. With oil companies I see these beings exactly the same, the profits that oil companies realize are more than enough to cover accidental oil spill every 20-30 years. With an insurance cap there really is minimal motivation to innovate at a fast rate since the insurance keeps the company/individual from bearing the full costs.

So instead of finding a balance between too much caution and too little caution (from the quote), I think more caution is always better!

Jennifer said...

Apoplexy,vociferous.. great words!

Sen. Robert Menendez in favor and Sen. Lisa Murkowski against the increased liability limits. What usually happens, who wins? Does the decision come down to party votes, or the bigger bank? Does decision making pertaining to consequences of negligent environmental outlaying usually end in compromise with a smaller increase?

The subject is new to me. It seems that $75 million to $10 billion has many numbers in between.

Jennifer said...

And in response to profits being enough to cover costs, if that's accurate, what are the values being addressed in the liability debate? Financial security vs. environmental security? Whose best interest is being debated?

Tonya Gray said...

This is a very interesting debate. The excerpt from the 1995 book after the Valdez spill is totally applicable here. What is really grabbing my attention though is something Jennifer mentioned before me, who's best interest is being debated? That of the individual or community or the interests of government and big corporations? Everyone knows that oil companies are among the most profitable in the country, so to me, it seems almost completely ludicrous for them not to have to be 100% responsible for the spill. Obviously, there had to have been an overlooked precaution here or there just to cut costs and raise profits. In my opinion, the idea of this incident as a "moral hazard" is what should really be focused upon. Maybe it is a wake-up call that will possibly push new waves of innovation- granted if companies would put more money towards innovating new techniques/what have you, which I think would be most beneficial to the future profits of the company rather than focusing on how much money they can pocket in the here and now. Certainly, if the oil company is faced with complete liability, events like this should rarely happen unless caused by some other external causation factor. The dangers presented in this case are too great not to be overly cautious. Though it can be bad to be on either extreme (too cautious or not enough), this situation should definitely, in my mind, fall within the realm of issues to be overly cautious.
I honestly don't really like the comparison of liability for the oil industry with the automobile industry, because this involves the spill of a precious natural resource which we are driving closer to depletion with each coming day - which I think cannot be accurately compared to liability insurance with cars, which typically only cause economical (fiscal) damages (although sometimes environmental, if it's a nasty wreck) but this oil spill concerns the welfare of millions - affecting a precious stock of gulf maritime animals, fishery profits, tourism revenues along the coast, and the health of all closely involved. This is a nasty accident which must be corrected with strong governmental repercussions, considering all of the strong societal/environmental/economical consequences which have ensued.
Gas prices are going up, and I think they will just continue to go up until this mess gets all cleaned up (figuratively and literally speaking, of course).

Peter Salyga said...

Hey Tonya, I think a comparison here to car liability insurance is most appropriate (for that matter even any other insurance system we run could very well be just as comparable.) Whether the outcome turns out to be an economic disaster or an environmental disaster, is not really the issue here at all. The point was just made to show that a similar philosophy exists behind all insurance systems (a moral hazard versus too much precaution). You write that an oil spill affects millions of people, and I completely agree, but doesn’t a broken car insurance or health insurance system affect just as many people? Whichever industry it may be, I think liability insurance hides the real cost associated with a disaster and indirectly halts innovation. The quote goes on saying this system is frail and in order for it to work there needs to be a balanced between “too much caution” and “too little caution.” Here I think we both agree where we say a system is more suitable when the individual bears more caution than too little caution

Jacob Stanley said...

Interesting article, especially the part stating that if oil companies were liable for 100% they would take more precautions regarding accidents.

Joel Garner said...

In the wake of the Gulf spill i feel that the overall effect will be felt throughout the U.S. The fishing industry will more than likely be diminished for a number of years due to the overwhelming spill. Americans will find more seafood and farm raised shrimp and other seafood products on their tables at higher than normal prices. There's no way to assess the damages and it frustrates me when people want and demand figures such as these. With this disaster on our hands and with the possibility of it moving closer to our coast who knows what the true cost will be. Can it even be measured in dollars? Better yet should we even worry about valuing it in dollars when the real issue is what will happen to our fisheries and how long will they be affected? Could it be a problem our grandchildren will have to deal with maybe. Crude oil is nothing to play with and its devistation will be felt throughout the U.S. I truely believe.

Jennifer said...

Our grandchildren will have consequences from all of our actions,both good and bad. The question is, which do we want them to experience more of?

Dr. Peter Schuhmann said...

I want to respond to Joel's question of whether or not we should attempt to value damages in dollars and if it is possible to do so.

First, yes, in fact it is quite possible to assess the damage in dollars. This is a big part of what resource economists do and we've been doing it for decades for resources around the globe. The damage from Valdez is a great example. There are thousands of other examples.

Valuation of environmental goods and services is not easy however, and requires a lot of data collection and econometric analysis. And of course the figure will be an estimate. I'll leave it at that for now... We'll learn about valuation procedures soon.

In terms of whether we should try to value the damages, I think the answer is a definite yes. Without an understanding of how much the damage is worth (in dollars) how can we know how much of a fine to assess the responsible party?

Further, much of society does not have our/your appreciation for what natural resources are worth. They do however understand dollars perfectly well. Valuation can serve to illustrate to society, politicians and policy makers that the resources that we tend to take for granted and use for "free" are in fact worth a great deal.

Valuation, though difficult, serves many important functions, and can go a long way toward enhancing conservation & preservation efforts.

here is some more reading on the subject: