Catastrophe avoidance and risk aversion: Implications of formal utility maximization

It is shown that von Neumann-Morgernstern (NM) expected utility maximization, as is currently practised, implies an upper bound on the percentage utility that can be sacrificed to reduce the probability or severity of a catastrophe. The major quantitative result of this paper is a simple tabular (and graphic) presentation of the maximum allowed budget for catastrophe prevention/abatement within the NM framework. The upper limit, which declines in proportion to catastrophe probability, effectively reduces the benefit-cost ratio for catastrophe protection. Use of formal utility maximization methods can thus result in the choice of policies that fail to avoid catastrophes that could be avoided at relatively low cost. Thus the decisions of risk-averse, risk-neutral, and risk-seeing utility maximizers tend to converge in catastrophe prone situations. The prospect theory of Kahneman and Tversky or the elasticity principle of Bernard offer more flexible options of risk aversion under these circumstances.Professor of Engineering and Public Policy, Carnegie-Mellon University, Pittsburgh.PhD candidate in Engineering and Public Policy, Carnegie-Mellon University, Pittsburgh and Assistant Professor, College of Business Administration, University of Nevada, Reno.