Abstract
When there are large numbers of government projects in which benefits and costs are uncertain, strong arguments have been made for ignoring people's aversion to risk and basing public decisions entirely on expected values. However, these arguments are weakened in cases in which risk-averse citizens can make private expenditures to reduce their own risk. A model is presented in which pollution damage is stochastic and households expend resources to reduce their exposure. If pollution is controlled by a Pigouvian tax set equal to expected marginal pollution damage alone and the additional burden of uncertainty borne by risk-averse households is not taken into account, it is shown that the economy will operate inside of its production possibility frontier. The article concludes with an example in the policy arena where this issue is likely to be an important one.
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