Farnam Street helps you make better decisions, innovate, and avoid stupidity.

With over 350,000 monthly readers and more than 87,000 subscribers to our popular weekly digest, we've become an online intellectual hub.

Recipes for Ruin, in the Gulf or on Wall Street

Richard Thaler comments:

AS the oil spill in the Gulf of Mexico follows on the heels of the financial crisis, we can discern a toxic recipe for catastrophe. The ingredients include risks that are erroneously thought to be vanishingly small, complex technology that isn’t fully grasped by either top management or regulators, and tricky relationships among companies that are not sure how much they can count on their partners.

How can government reduce the frequency and the severity of future catastrophes? Companies that have the potential to create significant harm must be required to pay for the costs they inflict, either before or after the fact. Economists agree on this general approach. The problem is in putting such a policy into effect.

Suppose we try to tax companies in advance for activities that have the potential to harm society. First, we have to have some basis for estimating the costs they may inflict. But before the recent disasters, companies in both the financial and oil drilling sectors would have claimed that the events we are now trying to clean up were, well, one-in-a-million risks, suggesting a very low tax.

Alternatively, an offending party could be made to pay after the fact, by holding it responsible for the costs it imposes. BP has volunteered that it will pay for all damages it considers “legitimate,” but we can expect a fight over how to define that word.

Twenty years after the Exxon Valdez accident, the payments are only now winding down. And many companies now operating rigs do not have BP’s big pockets. Suppose a company worth only $1 billion was responsible for this accident. It would go bankrupt and we would be unable to collect. And if we aren’t careful, we will encourage companies that have enough money for collection to leave the drilling to those that don’t…

Continue Reading at the New York Times

Read what you’ve been missing. Subscribe to Farnam Street via Email, RSS, or Twitter.

Shop at Amazon.com and support Farnam Street