Survey_KM_2007

Abstract

We first consider the case of two identical individuals (or firms) where there is no possibility of contamination from one individual to another and each individual has an opportunity to invest in mitigation to reduce its losses with premium reductions reflecting the reduced level of risk. We label this base case the No Contamination case. We compare this base case with a situation where there can be contamination between the two parties and where the two parties coordinate their actions. This case is labeled Contamination – First Best. It will be compared with a situation where the two parties cannot coordinate their actions and thus each party makes a decision independent of the other. This case is labeled Contamination – Second Best. We then turn to regulatory mechanisms that provide stronger incentives for agents to invest in self-protection and thereby internalize the externality if the two parties face the possibility of contamination and cannot coordinate their actions. We show that welfare can be improved by either a required deductible on each insurance policy or by making agents liable for losses to others and providing “at-fault” rather than no-fault insurance coverage.