Natural Disasters and Capital Replacement

by Don Boudreaux on July 6, 2008

in Myths and Fallacies

I was recently interviewed by a newspaper reporter who asked what I think of the idea that natural disasters make economies more productive by forcing the replacement of capital equipment embodying older technologies with capital equipment embodying newer, state-of-the-art technologies.

I don’t think much of this idea.  It’s got flaws aplenty (which now I leave to the astute patrons of the Cafe to identify).  But here’s a closely related flaw that that I will share now.

I got a skeptical response from the reporter when I told him that businesses often — and, likely, efficiently — replace capital embodying older technology with capital embodying newer technology.  They often make such replacements without being forced to do so by natural disasters, wars, or any other non-market phenomena.  Businesses will make such replacements when the net present value of the expected stream of additional profits made possible by the newer capital exceeds the cost of acquiring and implementing the newer capital.

“But do such replacements happen in the real world?” he asked.  “I’ve interviewed some economists who argue that people often miss these opportunities and hang on too long to older capital.”

“I disagree.  I see such replacement going on constantly.” I answered.  “For example, the supermarket nearest to my home was recently refurbished; it’s now much more attractive than it was previously.  But, as far as I can tell, there was nothing about the store in its pre-refurbishment condition that was unfunctional.  Another example is on-line banking: many [most? all?] banks now offer this service despite the fact that real-world bank tellers and ATMs remain functional.”

I could tell that he was still skeptical.

“Look,” I asked, “have you ever replaced a personal computer with a newer and better one even though your older computer was still working?”

“Yes.”

“So have I.  And so has everyone else I know who owns a computer. The undeniable frequency of such replacements – along with the equally undeniable fact that almost no one replaces his or her personal computer the moment a newer, more updated version hits the market – is strong evidence that people in the private sphere make reasonably sensible cost-benefit calculations about when, and when not to, replace older but still-functional capital equipment.”

I suspect that my response did very little to dent his skepticism of my claim that there’s no reason to worry that the market generally adopts new technologies too slowly.
….
Finally, although this reporter and I did not talk about international trade, it occurred to me afterward to wonder how many persons who worry that the likes of hurricanes and earthquakes are helpful in getting private firms to efficiently undertake modernizing investments that these firms would otherwise stubbornly resist also worry that the moment freer trade with a lower-wage country becomes reality that firms in higher-wage countries will rush headlong into moving their production facilities to such countries.  Just wondering.

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{ 45 comments }

Jason July 6, 2008 at 9:32 pm

I've always thought the same thing! Couldn't we stimulate the economy by having someone break the windows of local shops? That would create jobs at the glass making factories and so on. It's too bad economists never address these issues…(sigh)

Unit July 6, 2008 at 9:52 pm

Jason must be kidding?

So following the reporter's logic a bunch of businesses would have relocated in Mexico after Hurricane Katrina.

Sam July 6, 2008 at 11:15 pm

I like this argument for private firms and capital equipment, but what about public infrastructure and institutions? Politics is a messy affair, but part of me wonders if hurricane Katrina effect's on the political instituions of New Orleans (espeically the school board) won't have some long run benefits.

Unit, Jason was making reference to the works of Frederic Bastiat
http://en.wikipedia.org/wiki/Fr%C3%A9d%C3%A9ric_Bastiat

Swimmy July 6, 2008 at 11:21 pm

It really depends on the market, right? For instance, Robin Hanson thinks that hospitals are likely to buy new capital too early–to use methods and equipment without good track records. This is because patients are biased to think new = better.

But I agree that efficient capital substitution happens plenty often enough that, no, we still shouldn't be seeing a silver lining in natural disaster on this front. Even if old capital doesn't get replaced quickly enough, disasters don't discriminate against new capital either.

piperTom July 6, 2008 at 11:24 pm

I'll make another reference to Bastiat: the reporter's idea is that random disasters are smarter than business owners about when to upgrade equipment. The idea is ludicrous.

Eric Crampton July 6, 2008 at 11:27 pm

Funny…I just gave a talk for our local Golden Key society on war and economics…was basically a half hour on Bastiat and the Broken Window Fallacy for folks in final year high school. Here I was reaching back to Katrina for examples of the fallacy and had I looked here first, I'd have found more recent material.

BoscoH July 7, 2008 at 12:31 am

This is the perfect week to test the reporter's theory. There will likely be thousands of people lined up at Apple retail stores to purchase 3G iPhones after the impending earthquake/flood/hurricane. Perhaps the Apple retail stores constitute a betting market of sorts on natural disasters?

Sam Grove July 7, 2008 at 1:34 am

Granting the utility of a timepiece, everyone should have rushed out to buy digital watches when they became available, at a price of $1,500, rather than wait until until production efficiency made such devices much more affordable.

Every business will upgrade at about the time the that their accounting tells them it's the right time.

The only thing that makes such disasters financially bearable is either a lot of stored value and/or insurance, which defrays the cost by absorbing value that would have gone to other investments in future production.

Ask such a person if they think they would be better off if they wrecked their car so they would have to buy a newer model.

BoscoH July 7, 2008 at 2:11 am

@Sam… Of course they would be better off if they turned around and bought a gas saving hybrid. <grin>

Steve July 7, 2008 at 2:47 am

I've been to New Orleans twice now to demolish and rebuild homes. A few observations:
1) Rationing by wait is strong there. Plenty of people have the money to rebuild, but there are only so many contracters, even with the influx of profit seekers.

2) We truly live in a luxurious country when thousands of people can afford to go to New Orleans and give their labor to help others. In a "poor" country, no one would be able to spare their own profit earning time.

I also did a research project studying the damage in lives and dollars from hurricanes, in relation to two variables. #1: FEMA, FFI, and Wagner Act housing; and #2 economic progress. My conclusions:

1. Very few lives or dollars were lost in hurricanes pre-FEMA and FFI. People had to be bribed to overcome their risk aversion. Wagner Act housing tempted people to stay in areas where there were no jobs- stacking people in poverty for generations. The ACE levy projects created livable land on what show as lakes on old maps.

2. Our progress and economic growth has allowed us (even given the conditions of #1) to trade dollars for lives. News footage shows people atop firm houses, waiting to be rescued. In Burma, there were no comparable houses to sit atop while waiting for rescue. Although we shouldn't be tempting people to overcome their risk aversion- I'll take the protection of trading money lost for lives saved any day.

vidyohs July 7, 2008 at 6:12 am

My thoughts on reading Don's post went immediately to the same point that Swimmy expressed. Natural disasters aren't selective in what or who is damaged.

In support of Don's rebuttal to the reporter is the evidence of the automaker assembly line. Robotics was not resisted as much as it was proven before the bandwagon was jumped on by automakers in general. Once the evidence was in that robotics was reliable and cost effective, in came the machines and out went the less efficient man.

But, such questions from people just remind you that there are multitudes out there that have no clue as to what a business is and how it must be run in order to produce profit.

There is no one size fits all model of how to to run a business. A business is typically a reflection of the thinking of the man that created it. But, it is certain that the underlying motive for opening a business and doing business is profit and those who do not pursue it as number one priority are soon history.

John Dewey July 7, 2008 at 7:56 am

swimmy: "Robin Hanson thinks that hospitals are likely to buy new capital too early–to use methods and equipment without good track records. This is because patients are biased to think new = better."

I wonder whether most hospitals consider patients or physicians to be their primary customers. A surgeon represents a huge potential flow of cash to a hospital, from OR fees plus post-surgery patient recovery. Competition for those cash flows motivates hospitals to invest in more modern operating room equipment. My wife, an operating room nurse for 30 years, tells me that surgeons of all specialties are constantly playing one hospital against another to force equipment upgrades.

I would be surprised if hospitals really use equipment with poor track records. What data does Robin use to support this assertion? Does Hanson mean that the equipment doesn't do the job it's supposed to do, or simply that less expensive equipment can do the same job?

Swimmy, can you provide a link to the Robin Hanson essay?

andy July 7, 2008 at 9:05 am

I am absolutely astounded at the ignorance on display!
Has this brainless idiot taken 5 minutes to look at a co.s balance sheet? The amount spent on capex in the US is huge. Amortization of equipment is fast and replacing old equipment is something that happens as a matter of course. The idea that you need an external stimulus… and that disasters are the most appropiate…
I understand that you like to educate, but your restraint from physical violence against this subject bespeaks real zen. I couldn't do it.

John Snow July 7, 2008 at 9:12 am

"I got a skeptical response from the reporter when I told him that businesses often replace capital embodying older technology with capital embodying newer technology."

Not "often". Always. You should have turned the tables on him and asked him to name an example of one single business that still operates with the same hardware as 50 years ago.

save_the_rustbelt July 7, 2008 at 9:12 am

Don is largely correct on this, but he may overestimate the efficiency and logic of the process. There are plenty of missed opportunities, but then hindsight is a lot smarter than foresight.

Hospitals make decisions for lots of reasons, some of them not very economically efficient, but that is for another day.

(Many years ago I heard the theory that the Japanese and German economies got an advantage from WWII, we bombed most of their industrial capacity into dust and they had to modernize. Disclaimer – I have no idea if that is correct or not.)

(Also, Jason's theory has been around, perhaps in hypotheticals in some econ texts, I do not recommend that idea though.)

In my part of the world the largest natural disasters are flooding, and I do not see major floods as causing anything but lots of cleaning and remodeling, which does stimulate the contractor economy and the local lumber yards. A very tough way to modernize though.

Matt C. July 7, 2008 at 9:28 am

save-you have missed the point of the broken window fallacy. Just because it may stimulate the economy in the short run, in the longer run you lose out on savings. It could be that maybe in the near future better technology would come along and you have just dumped a bunch of money into something that wouldn't be as cost effect and efficient as that new technology, but that is always a risk. But better to make the decision on your own rather than mother nature doing it for you.

Paul Zrimsek July 7, 2008 at 9:35 am

On a similar note, I've often wondered how many people who believe that businesses don't look past the next quarter also believe that those same businesses would try to drive their competitors out of business by predatory pricing if they weren't prevented by antitrust laws.

vidyohs July 7, 2008 at 10:11 am

I also meant to comment on this:

"It's got flaws aplenty "

Ouch, Don!

Is that "It is got flaws aplenty"?

or

Is it "It has got flaws aplenty"?

Ouch and Ouch again.

Hammer July 7, 2008 at 10:14 am

John Snow: Many of the larger raw materials type industries do use older equipment. The chemical company I work for has many reactors and compressors that are older than I am. However, they do get tweaked and adjusted to improve capacity on a regular basis. Similarly, I am given to understand that many oil refineries and metal smelting operations are still using the older equipment.
The reason for this is exactly as Russ said: they work well enough that the massive investment to replace them is not worth it. Thus "often" is more appropriate than "always". Compared to the micro-chip industry, one would be pretty accurate to say some industries "never" change their equipment, at least relatively speaking.

To save's point, Japan and Europe benefitted because the USA paid for a lot of that new equipment.
In general, random destruction never benefits the owners of the destroyed. If nothing else, one can sell older capital equipment on the secondary market, or even just for scrap, and come out ahead of having it just ruined.

tiger July 7, 2008 at 10:39 am

Don, You are so correct. This myth is particularly popular in "hurricane" country (Southeast Florida) where post-storm repairs and rebuilding cause what looks like a spike in productivity, employment, spending, investment, etc. All of that perception is silly, money is transferred from both private and government capital sources like insurance companies, FEMA, SBA and the like. It is all recollected in form of higher premiums, taxes, levies, and user fees. After the roofs are back on, we have locally higher unemployment, lower spending, less investment and more requirements for public assistance. And, the local shortage of supplies and labor causes these things (like roofing materials and roofers) to flood our area. This makes finding a roofer in say Tallahassee or Jacksonville and serious problem post-storm. And when you do find one, the cost of your new roof (in areas not impacted by the storm) are considerably higher. None of this adds a thing to a city, county, state or national economic growth.

JohnSnow July 7, 2008 at 10:41 am

Hammer,
Raw materials have been in the doldrums for almost 30 years, that is why the bull in commodity prices is just getting started. Even so, capital replacement on a massive scale still goes on. Those huge 3 storey-high tractors that miners use only take 10 years of heavy use to get completely worn down. Even oil tankers have a shelf life max of 20 years, which means that many companies replace them after 5 and resell them to less efficient ones before they lose too much value. Not to mention the airline industry, where many companies refuse to own more than 20% of their fleet, leasing the rest, so that they can get new (more fuel-efficient) models after a few years….

If you go to any auto plant outside the US, you'll see the robots are 2 or 3 year old models max..

John Snow July 7, 2008 at 10:44 am

But I do have to give you credit for answering my challenge with an example.

Could you please provide more details?
Thanks.

Unit July 7, 2008 at 11:03 am

Let me try to find the silver lining: it seems like a lot of people in New Orleans were trapped in a dysfunctional relation with government pseudo-welfare. As opposed to businesses, governments do not adopt innovations as easily. So, the fact that Hurricane Katrina forced a lot of people to relocate in different municipalities might have been a good thing. I'm speculating.

John Dewey July 7, 2008 at 11:08 am

Hammer: "Similarly, I am given to understand that many oil refineries and metal smelting operations are still using the older equipment."

I wonder about the age of equipment in refineries. When I briefly worked in a refinery 33 years ago, equipment was constantly being refurbished and replaced. My father worked in that same refinery for four decades, and saw many processes automated over his lifetime.

Environmental laws make it near impossible to build new refineries in the U.S., so refining companies have kept up with demand by expanding their existing refineries. As they expand, I'm fairly certain they are introducing new methods and more efficient equipment.

One example of recent innovation in refining is a distillation column flooding predictor. This computer software enables refineries to operate at higher capacities by reducing the risk of distillation tower flooding. The U.S. Department of Energy has estimated that plants might realize 2 to 5 percent more throughput.

OregonGuy July 7, 2008 at 11:52 am

A topic touched upon by swimmy, John Dewey and save_the_rustbelt, in the case of hospitals, much of their decision is based upon the need to show that they have not been negligent. Latest do-dad? Gotta have it or face potentially devastating tort claims.

I consulted on an employee-owned corp back in the early '80's. We drew up plans to convert their mill into an efficient operation. In the first year alone, reductions in maintenance and increases in electrical efficiency would have led to savings three-fold greater than the cost of recapitalization than their current operating costs.

They, instead, declared a dividend to the employee-owned stockholder shares. This plywood mill was out of business–due to competitive pricing–within three years.

After all, in the long run we're all dead.

.

KMcC July 7, 2008 at 12:25 pm

Here is the stupid article in all its stupid glory:

http://www.boston.com/bostonglobe/ideas/articles/2008/07/06/how_disasters_help/?page=full

It's worse than Don makes it sound in his original post: it contains an egregious misunderstanding (and therefore misapplication) of Schumpeter's idea of creative destruction.

And it mentions Naomi Klein as if she had any grasp at all of the subjects she deigns to write about.

Drivel from start to finish; shame on the Boston Globe for giving its imprimatur to such a pile of errors and incomprehension

bbartlog July 7, 2008 at 12:27 pm

I think part of the problem is that you've accepted the reporter's formulation 'make economies more productive' at face value, rather than questioning what this means and whether it's always good. If we neglect the value of leisure we can certainly imagine that a disaster would result in increased economic production as everyone busily rebuilt what was destroyed, but this doesn't mean that people are better off.
Anyway, specifically as regards the question of capital improvements that boost productivity: one trivial way that the reporter could have a point is if we assume that some of the business owners are irrational. Maybe they are too risk averse, or don't correctly evaluate the benefits of capital improvements.
Another more contrived example: Some capital improvement exists in rudimentary form, but the costs of developing it fully are so large that it does not make sense for any individual corporation to do so. If a disaster annihilates the equipment of many producers at once, it may solve the coordination problem they would otherwise have in implementing the new technology.

Hobson July 7, 2008 at 12:28 pm

I don't disagree with Don's response. It did not, however, deal with the kernel of truth implicit in the reporter’s question. Because imperfect human beings make the decisions as to whether will be wealthier by continuing to use an old item or replacing it with a new one, the resulting decisions will not be perfect. Moreover, some people might know that it would be better in the long run to replace something, but don’t have the funds to do so now. So some items in the path of a hurricane will be forcibly replaced to positive economic impact.

Neither does the broken window fallacy fully deal with the errors in the reporter’s assumptions. Essential to it being a fallacy is the assumption that all windows are more valuable unbroken than broken. Anyone with an imagination could dream up a scenario where such is not the case (consider R factors for example).

What does address the reporter’s question, as "Steve" noted above (but didn't elaborate), "Natural disasters aren't selective in what or who is damaged." Because for the most part people replace stuff that has outlived its useful life, most of the stuff in the path of a hurricane has plenty of useful and efficient life left in them. Moreover, the new stuff will, on average, be much more valuable than the old stuff. Surely the value of the destroyed useful stuff will vastly outweigh the value of the inefficient stuff that a hurricane would cause to be replaced.

A better answer to the reporter would have pointed out that he had identified an extremely thin silver lining to an otherwise large and destructive cloud.

Don July 7, 2008 at 2:16 pm

I feel very sorry for firms operating from locales with very low incidence of natural disasters. Just think, they have to wait and wait and wait for a disaster to hit in order to upgrade to more modern, efficient equipment. Somewhere there must be an earthquake/flood deficient location where they still make steel with pre-Bessemer technology.

John Dewey July 7, 2008 at 3:13 pm

OregonGuy: "in the case of hospitals, much of their decision is based upon the need to show that they have not been negligent."

I'm sure there's some fear of negligence. Defensive medicine – especially the ordering of medical tests – is a reality delivered to us by outrageous jury awards.

My wife, a former OR manager who has directly dealt with surgeon's requests for equipment, tells me that equipment upgrades are more often just a case of competitive pressure. A surgeon gets access to new, easier-to-use equipment at a new hospital. The surgeon then tells the older hospital that they want the new equipment for all their surgeries. The older hospital must either upgrade or risk losing the revenue generated by the surgeon.

John Dewey July 7, 2008 at 3:24 pm

Hobson: "some people might know that it would be better in the long run to replace something, but don’t have the funds to do so now."

I think that's true, Hobson, even for very profitable companies. For several years I analyzed and prioritized large capital requests for a large and rapidly-growing transportation compay. Some projects would have saved our firm money if implemented. But the net present value of many such projects fell far below that of other capital requests. Capital for all the projects could have been found, but at a progressively higher cost as more debt was assumed. Further, the management talent to implement all feasible projects at once was just not available.

Dano July 7, 2008 at 4:39 pm

The abstract to "Economic Development and the Impacts of Natural Disasters" by Mark Skidmore and Hideki Toya (the reporter used Skidmore as an expert agreeing with the hypothesis): "We use disaster impact data over time to examine the degree to which the human and economic losses from natural disasters are reduced as economies develop. We find that countries with higher income, higher educational attainment, greater openness, more complete financial systems and smaller government experience fewer losses."

Higher income, higher education, greater openness… sounds much like the preventative checks Malthus wrote about. So wouldn't that indicate it isn't a natural disaster forcing progress but a society that better copes with natural disasters?

Gil July 7, 2008 at 10:43 pm

Thanks to KMcC for the original article. Maybe some here didn't like the insinuation because the productive element (rather than the redistributive) is that of eminent domain. The poor competitors get ousted as they can't afford to rebuild but the better-off competitors can expand. Then again I'm sure Conservatives like vidyohs would remind us that adversity sorts out the weak from the strong. 'Tis laughable people here did their best to create the 'simple Wiberal who doesn't understandz economiks and hazzint herd of the story about the Broken Windows' strawman – never mind the author addressed the issue of mere redistribution and didn't for a cheap 'war/disaster is good for the economy because of the work for the carpenter and briclayer' argument.

jpm July 7, 2008 at 11:18 pm

more ad hominem from Gil duck, telling us that Wiberals actually DO understand economiks but in the next breath can't refute the Broken Windows' analogy and we all note he doesn't dare try. Instead, we get a demonstsration of his mastry of economiks by explaining how, without those helpful and altruistic natural disasters, the rich would only get even richer which causes the poor to starve!

I know, don't feed the troll, but when we get such a hanging pitch, how can anyone with an ounce of common sense resist mocking him out of the park.

Gil July 8, 2008 at 4:26 am

Actually I was thinking more in line of 'natural disasters could cure the Tragedy of Anti-Commons'. Then again the Black Death help wreck the feudal system and saw increasing wages. Not to mention the Great Fire of London helped to destroy the last hot spots of the Plague.

Still there's a 'so-what' factor. Who cares? Natural disasters are a fact of life. The smart productive people are going to avoid disaster-prone areas and have a greater ability to recover if disaster strikes.

save_the_rustbelt July 8, 2008 at 8:54 am

"save-you have missed the point of the broken window fallacy."

I didn't make any comment, I just mentioned I had heard the idea before.

save_the_rustbelt July 8, 2008 at 8:57 am

Don may have missed one aspect of the decision process.

Revenue projections are a major part in many of the decision, and revenue is based on marketing projections and estimates.

Sales and marketing are notoriously fuzzy, unless a business is mature and very stable (less frequent these days).

Accordingly some bad investments are made and some investments with a positive NPV are missed.

Frederick Davies July 8, 2008 at 9:29 am

What is it about the "broken windows" fallacy that is so attractive? I mean: Come on! Economists have been making fun of this for more than a century, and it keeps coming back. There is a Psychology thesis in there for someone.

Hammer July 8, 2008 at 10:10 am

John Snow: Raw materials are not so bad as you might think, at least in certain markets and products. Any chemical that goes into making semiconductors seems to be doing pretty well, or at least the companies that make the vast array of chemicals needed.
In the bulk liquid gas field you have BOC/Linde, Air Products, Air Liquide and a few other smaller operations I am no doubt forgetting. Many of the plants that make, say bulk nitrogen, are really pretty old, containing electric motors that need to literally be cut out of the building to be removed or replaced. The main reason for this is that the overall technology has not changed a great deal since the 70's.

Now, things certainly do get replaced and upgraded. Computerized bits get added, coils get replaced as they go bad, things like that. The big pieces do not, in this case the electric compressor motor. I suppose one could choose an arbitrary number of parts that need to be replaced before it is "new", but I would say for example that putting in new seats, an alternator and a battery does not necessarily make a car "new", either.

The distinction would be to me that in a serious natural disaster the majority of equipment would be a total loss. That hugely expensive and unique electric motor is now an expensive mountain of scrap metal. Compared to that, the constant effort of replacing broken parts and doing continuous improvement programs to tweak the system seem much less like "replacement" and more like "maintenance."

Hammer July 8, 2008 at 10:14 am

Frederick: If I had to hazard a guess, it is because it is just counter intuitive enough to make someone think it takes great understanding to come to its conclusion, yet is simplistic enough for someone without any real understanding to grasp.
That, and perhaps because it suggests we laud someone for being naughty, which seems to be a pretty general theme in leftist thinking.

Someone here made a mighty statement the other day that I have been paraphrasing mercilessly ever since:
Communism's appeal lies in the fact that it simplifies a tremendously complicated system down to the point that any idiot can understand how it is supposed to work.

John Dewey July 8, 2008 at 11:31 am

rustbelt: "Sales and marketing are notoriously fuzzy … Accordingly some bad investments are made and some investments with a positive NPV are missed."

I agree that revenue projections are almost always wrong, but not always on the high side. Projecting the behavior of customers (revenue) is generally more difficult than predicting the behavior of the internal organization (costs). We should expect sales and marketing estimates to be less reliable, and they are, as you point out.

Positive NPV investments are missed, but probably due to conscious decisions as often as due to incorrect estimates. Most organizations just do not have the resources to pursue every proposal. Prioritizing capital spending opportunities is a critical job for the large company.

Scott Anderson July 8, 2008 at 3:26 pm

There are so many good comments here that I am not certain mine can be read but here it is.

A weather event destroys capital. The exisitng physical capital is destroyed by the weather, the financial capital of insurance is destroyed by having to replace the physical capital. The insurance capital is invested before being payed as a claim. Once it is payed it no longer finances another market determined worthy investment. There is less capital.

In the broken window analogy. The glass maker benefits when an window of a shop is broken but the shop owner has less money after replacing the window. The suit maker has fewer sales because the shop owner buys a window instead of a new suit. Opportunity cost!

That being said, there is a very good article in HBR by Clayton Christensen about "innovation Killers – How Financial Tools Destroy Your Capacity to Do New Things"

One of the misapplictions of finance is to use fixed and sunk costs unwisely. He uses the steel industry as an example. Some integrated steel makers refused to innovate because of their embedded capital. This does not relate directly to the weather example unless we assume that some industries are slow to innovate because of the misapplication of financial principles and get a nudge from mother nature. But of course their insurance rates will increase and must pay either way.

Swimmy July 8, 2008 at 4:55 pm

John Dewey:

Sorry, I forgot about my comment here. You can find Hanson's general argument about the problems with health care in Cato Unbound:

http://www.cato-unbound.org/2007/09/10/robin-hanson/cut-medicine-in-half/

I'm having trouble finding the data he uses to support the particular claim that new treatments are often ineffective. I believe he's using the RAND study and other aggregate studies that find no significant correlation between better health and health spending after a certain point, and extrapolating that new treatments and equipment are likely to be expensive.

I thought about the whole natural disaster thing a little more. (Forgive me if someone already said this; this blog generates a lot of comments these days!) Like I said before, disasters don't discriminate between old and new capital. They're equal-opportunity destroyers, barring some major exceptions–obviously newer buildings tend to have better safety standards than older buildings, but the vast majority of capital replacement we're talking about isn't on this scale. The reporter could still be right if, in fact, businesses are biased to not replace capital often enough. There could still be enough old vs. new capital that a natural disaster prod could fix a market failure. This would also depend on the rate of disaster. One every year would have a much worse effect on capital substitution than one every ten years.

But imagine you're a shopkeeper. You know that disasters don't discriminate. You also know (approximately) the rate of natural disaster in your area. You think you can refurbish your shop, change out your capital, and thereby better serve your customers. Do you? It depends on the risk of a disaster hitting the new capital versus the profit you would make from serving your customers. If you live on the Florida coast, it might be very risky to go ahead and make the capital substitution.

In this case, natural disasters aren't the cure for a market failure of capital substitution–they're the cause. The shopkeeper is absorbing the risk by losing some profit, while customers are absorbing the risk by shopping in a less efficient store. Seems to me that they're all spending the right amount, now that the cause is uncertainty rather than bias. It's as efficient a solution you can get in such a case. I think it's reasonable to believe this is more likely than a bias against capital substitution.

John Dewey July 9, 2008 at 9:59 am

scott anderson: "One of the misapplictions of finance is to use fixed and sunk costs unwisely. He uses the steel industry as an example. Some integrated steel makers refused to innovate because of their embedded capital."

I wonder, Scott, how much of this is due to short term horizon of some executives and how much is due to executive egos. In past decades executive compensation systems tended to reward short term performance and ignore long term competitiveness. Such systems could inhibit executives from spending capital to increase long term gains – especially if replacement capital also entailed the write-off of prematurely retired assets. But I think most executive compensation systems have been tweaked to reduce such short term bias.

An equally difficult problem has been the emotional ties executives have to existing operations and capital. One man I worked for – one of the most admired CEO's in the U.S. – was unable in the 80's to let go of a failed pet project draining hundreds of millions from his otherwise outstanding company. IMO, it was a matter of saving face. The Space Shuttle Challenger disaster gave him an out. He was able to blame the demise of his project on the inability to launch satellites, a critical success factor. Zapmail's demise wasn't an example of a disaster forcing a capital expenditure for new technology, but rather a disaster enabling a redeployment of resources.

Scott Anderson July 9, 2008 at 12:59 pm

John,

Your comments are well taken. I have been in many situations where executives, particularily senior ones, have embeddd mental models of how their business works – not taking into account the inevitable evolution in their industries. In these situations, financial analysis may be viewed more as a confirmation of their intuition than as an input.

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