Given that natural disaster prevention measures have the characteristics of a public good, economists and actuaries conventionally measure their value through either a revealed preference approach or a stated preference approach.1
Using a revealed preference approach, costs are estimated by observing individuals’ perceived ability to substitute between a public and a private good. In our particular case, using a revealed preference approach you can infer the value of disaster prevention measures from how much people are willing to pay for them, as if they were private goods. The derived values are then used to help design risk transfer mechanisms, such as insurance premiums, which are offered to the public. Individuals’ willingness to pay for disaster prevention measures depends on their expectations of how these measures will affect their utility. Because these expectations are commonly flawed where risks are complex or not well-understood, this method can understate or overstate demand for prevention measures (Luechinger and Raschky 2009). For example, Troy and Room (2004) finds no price discounts for houses located within a hazard zone before the passage of a state’s natural hazard disclosure law, but a large price discount thereafter.
Using a stated preference approach, individuals are directly asked to disclose their demand for natural disaster prevention through carefully designed surveys using hypothetical markets. However, this approach can be cognitively demanding for participants and may produce unreliable results. In a study of a flood reduction project in the United States, 15 per cent of the respondents could not attach a monetary figure to the project, although its characteristics had been carefully described to respondents in interviews only two years after a major flood occurred (Thunberg and Shabman 1991).
Our study provides an alternative approach that addresses the weaknesses of the conventional methods described above. Specifically, we use subjective wellbeing data to derive cost estimates of natural disaster impact. Kahneman et al. (1997) was the first study to provide a rationale for life satisfaction measures in economic analysis. This study was also the first to show that life satisfaction can be an adequate empirical approximation of experienced utility, where this is measured by considering respondents’ answers to life satisfaction questions in pre- and post-event surveys. Experienced utility is distinguished from decision utility, which is a representation of preferences over choices. Kahneman and others relate experienced utility to hedonic experience, which can be reported in real time or in retrospective evaluations of past episodes. Literally, experienced utility refers to ‘enjoying’ while decision utility refers to ‘wanting’. They argue that experienced utility is not only measurable but also of fundamental importance for understanding individuals’ behaviour and selecting public policies.
As described above, revealed and stated preference methods generally refer to decision utility. For instance, people’s willingness to pay for avoiding a natural hazard, which reveals their valuation of disaster prevention measures, depends on their expectations as to how those measures will increase their utility. Likewise, people’s stated willingness to pay for preventative measures depends on their expectation of the utility of those measures. To capture the value of non-market goods, both revealed and stated preference methods require that individuals can accurately predict the utility of their choices.
Using survey data on SWB to value non-market goods does not rely on individuals’ choices, but on the statistical associations between individual SWB and indicators of non-market goods,2 and between SWB and income. We note here that the concept of SWB encompasses both happiness and life satisfaction and that SWB, happiness and life satisfaction are highly correlated with each other as they yield the same qualitative insights (Frey and Stutzer 2002). In practice, reported SWB can serve as an empirically adequate proxy for an individual’s experienced utility as (i) it reflects the individual’s global evaluation of their life, (ii) it reflects both stable inner states and current affects and (iii) respondents’ evaluations refer to present life, i.e. to flow-utility (Luechinger and Raschky 2009). On a technical note, it is standard practice to impose modelling assumptions in the empirical exercise. One of the key assumptions presumes that a positive monotonic relationship exists between SWB and the underlying true utility, which means that for an individual i at times t and s, if SWBit > SWBis, then his or her utility will be Uit > Uis. A second standard assumption employed pertains to the ordinal interpersonal comparability of the SWB level: that is if SWBit > SWBjt, then for individuals i and j.3
Economists have used this subjective wellbeing approach to measure the wellbeing impacts of events such as inflation and unemployment (Di Tella et al. 2001), inequality (Alesina et al. 2004), terrorism (Frey et al. 2009; Metcalfe et al. 2011), civil war (Welsch 2008a) and corruption (Welsch 2008b). Several subsequent studies have now established a clear link between major life events such as marriage, divorce, disability, unemployment and financial shocks on life satisfaction (Lucas and Clark 2006; Oswald and Gardner 2006; Oswald and Powdthavee 2008; Lucas et al. 2004; Di Tella et al. 2010). For natural disasters, using self-reported wellbeing metrics has been shown to be an effective alternative to measuring the full impact of extreme events. Frijters and Van Praag (1998) uses life satisfaction data in Russia in 1993 and 1994 to predict the costs of climate change. Luechinger and Raschky (2009) uses life satisfaction data in Europe between 1973 and 1998 to estimate the costs of floods. More recently, in Japan, Rehdanz et al. (2015) uses the same approach to find that the decrease in happiness in survivors exposed to the Fukushima nuclear disaster in 2011 is equivalent to a 72 per cent reduction in annual income. In Australia, Carroll et al. (2009) finds that a decline in life satisfaction from spring droughts corresponds to an annual income loss of $18,000.
Footnotes
[1] Public goods have two distinct aspects: non-excludability and non-rivalry, implying when individuals make decisions about buying a public good, a free rider problem can arise, in which people have an incentive to let others pay for the public good and then to ‘free ride’ on the purchases of others.
[2] In the case of natural disasters, the indicators could be frequency or severity of a disaster.
[3] Ferrer-i-Carbonell and Frijters (2003) discusses these assumptions in greater detail.
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