The Risk Management Dilemma

Abstract

Market processes play a central and constructive role in allocating risks, but impediments such as inaccurately perceived risks and externalities create a potential role for government intervention. Individuals overestimate small risks, are averse to imprecisely understood risks, and give excessive weight to errors of commission over errors of omission. The challenge for the government is to strike an appropriate balance in its risk regulation efforts and to avoid institutionalizing common irrational responses to risk. Excessive expenditures on risk reduction, often undertaken by or required by government, not only squander resources but also may increase risks to us all; they can divert expenditures that could have been used to enhance our standard of living and, directly or indirectly, our health. Risk equity concerns often prove problematic: they may direct excessive attention to unimportant risks and hinder efforts to deploy resources to produce the greatest gains in societal health status.

Get full access to this article

View all access options for this article.

References

1. See Willard Manning et al. , The Cost of Poor Health Habits (Cambridge, MA: Harvard University Press, 1991).

By contrast, the largest financial losses associated with disasters have occurred more recently. Other than the Great Chicago Fire of 1871, the most costly fire was the Oakland wildfire of 1991. The most costly insured hurricane was in 1992, and the most costly U.S. earthquake was in 1989. For data on these and other financial losses and catastrophes, see Insurance Information Institute , Property/Casualty Fact Book (New York: Insurance Information Institute, 1994), pp. 77-85.

3. For a discussion of the role of publicity, see Paul Slovic , “Perception of Risk,” Science, 236:280-285 (1987).

4. Thomas Schelling, personal communication, 1995.

5. See Richard J. Zeckhauser and W. Kip Viscusi , “Risk Within Reason,” Science, 248(4955):559-564 (1990).

The rationale for lower-income people to choose riskier life-styles is examined in John Pratt and Richard Zeckhauser , “Willingness to Pay and the Distribution of Risk and Wealth” (Working paper, Harvard University, 1995).

7. The framing of risk problems has a considerable effect on how risks are viewed and what preferences are expressed. See Daniel Kahneman and Amos Tversky , “Prospect Theory: An Analysis of Decision Under Risk,” Econometrica, 47:263-291 (1979). For example, car accident rates per trip appear negligible, but when expressed as annual or life-time fatality rates, they seem considerable.

8. Time, 26 June 1995.

9. Asymmetric incentives help explain this. There is little penalty for not approving a drug that would have saved statistical lives, but allowing a drug that has identifiable adverse effects, such as thalidomide, would impose enormous political costs. For further analysis of the excessive conservatism of the FDA, see Henry G. Grabowski and John M. Vernon , The Regulation of Pharmaceuticals: Balancing the Benefits and Risks (Washington, DC: American Enterprise Institute, 1983).

10.

10. Advocates of environmental equity in Chapel Hill, NC, which has traditionally sited landfills in rural areas, have proposed balancing risks by siting a new one near heavily populated residential areas. Severely increased risk will be the inefficient outcome.

11.

11. See Richard J. Zeckhauser , Ryuzo Sato , and John Rizzo , “Health Intervention and Population Heterogeneity: Evidence from Japan and the United States” (Monograph, National Institute for Research Advancement, Dec. 1985), p. 29.

12.

12. See W. Kip Viscusi , Fatal Tradeoffs: Public and Private Responsibilities for Risk (New York: Oxford University Press, 1992).

13.

13. Martin Marietta Energy Systems , “An Application of an Interim Version of the Formal Priority System to Fiscal Year 1992 Environmental Restoration Planning” (Report to the U.S. Department of Energy, Nov. 1990).

14.

14. For a review of these trends in regulatory expenditures, see W. Kip Viscusi , John Vernon , and Joseph Harrington, Jr. , The Economics of Regulation and Antitrust (Cambridge: MIT Press, 1996).

15.

15. See Albert L. Nichols and Richard J. Zeckhauser , “The Dangers of Caution: Conservatism in Assessment and the Mismanagement of Risk,” in Advances in Applied Micro-Economics, vol. 4, ed. Kerry Smith (Greenwich, CT: JAI Press, 1986), pp. 55-82.

16.

16. A number of pieces of legislation proposed or passed by Congress in 1995 would address both the mean risk and benefit-cost issues. These include Senate bill no. 333 and House bills nos. 1022, 690, 228, and 1923.