Economics Research Seminar

“Misfortunes Never Come Singly: Managing the Risk of Chain Disaster”

Large economic, ecological, natural and health-related disasters have the potential to set off a sequence of secondary calamities, initiating cascading effects that impose substantial additional economic costs. This paper examines the repercussions of contagion effects for optimal public policy. We compare the optimality of precautionary measures taken ahead of time with a ”reactive” approach to disaster management, i.e. disaster-mitigation efforts adopted after the gravity of the first shock has been established. We develop a novel dynamic stochastic framework, where disaster arrivals are modeled via the Hawkes process which possesses a self-excitation mechanism. We derive analytical solutions and show that the optimal policy consists of devoting a stochastic fraction of output to disaster-mitigation. The mitigation propensity is an increasing function of the Hawkes intensity and essentially tracks disaster arrivals. The latter implies that the policy is indeed reactive. This result is in contrast with the existing literature, which does not take into account the possibility of contagion and therefore finds a constant mitigation propensity to be optimal.