BENEFIT ANALYSIS, FLOOD RISK, AND THE THEORY OF THE FIRM

Flooding causes casualty losses whose size and future date of occurrence are not known with certainty to flood plain occupants. For the last 100 years, the Federal government has attempted to reduce flood damage losses through public investment in flood control. Since there are no market prices to determine the efficient allocation of resources for flood control, economic efficiency requires that the benefits from flood control be imputed. One measure of these benefits is the value of the additional monetary returns to flood plain occupants resulting from flood control. The current Federal government benefit methodology assumes that individual decision makers are risk-neutral and, therefore, willing to pay the full value of these additional returns for flood control. If decision makers are not neutral toward risk, however, this approach may understate or overstate the true benefits from flood control.;The firm subject to flooding faces a stochastic tax on capital by nature so that the level of profits is a random variable. The effects of risk preferences are included by assuming that the entrepreneur maximizes the expected utility of profits. The theoretical model shows that the risk-averse entrepreneur at a flood prone location considers the risk as a cost of capital in addition to the flood damages to capital. The risk-averter, therefore, produces less output and employs less capital relative to labor than if he were risk-neutral. For the risk-taking entrepreneur, the risk reduces the cost of capital so that the risk-taker produces more output and employs more capital relative to labor than if he were risk-neutral. In addition, if the rental value of land is the surplus return to capital in excess of the cost of capital, the risk-preferer accrues a larger surplus and will outbid risk-averters for the use of flood plain land.;The firm may also be willing to pay to transfer the risk by purchasing flood damage insurance. For the risk-averse firm, the alternative of flood insurance results in more flood damages by reducing the perceived cost of capital. Flood insurance purchased by risk-preferers raises the perceived cost of capital by eliminating the desired risk of loss and, therefore, reduces flood damages. Risk-preferers, however, are unwilling to voluntarily purchase flood insurance.;The inclusion of risk-preferences other than risk-neutrality broadens the sources of flood mitigation benefits. The reduction in the risk itself, may, depending on risk preferences, provide a willingness to pay in addition to flood damages avoided.;This research develops a model of the flood prone firm incorporating the uncertain nature of flooding and flood damages. This model is then used to determine the effects of alternative risk preferences on the optimal output and input combinations of the firm and on the amount the firm is willing to pay for flood control.;The input substitution prediction from the theoretical model was tested using capital stock, employment and flood damage data for a sample of flood prone firms. The results of the analysis indicated that the sample firms are risk-takers with respect to flood risk. This suggests that benefits may be overstated by the current estimation methodology. In addition, mandatory flood insurance is an effective alternative to flood control to reduce annual flood damages.