Tsunami - The Economics of Natural Disasters

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Note to Teachers:

Format

In the interest of providing an immediate resource for teachers to use as school resumes after the winter holiday, this Hot Topic is a truncated version of the usual format. It includes discussion questions, or "talking points," and a teacher guide, but relies on student knowledge of the tsunami from media coverage. There is no student reading handout.

Caution

For some students, the objectivity of economic analysis may appear callous in the face of the human loss and suffering they've seen on TV and the Internet. While economic language and reasoning are invaluable tools in helping students think clearly about responding to the tragedy, it would be a mistake to ignore the human elements. Remind students that the aseptic approach of economic analysis is not intended to diminish the reality of human suffering, but to give us a mental model of how best to alleviate it.

Overview

Estimates of the loss of life and of property damage and destruction in the tsunami's wake are being revised almost as they are published. However, a good early description of the cause and effect can be found in the December 31st issue of The Economist, excerpted below.

SO MASSIVE was the undersea earthquake that struck near the Indonesian island of Sumatra early on Monday December 26th that the entire planet may have wobbled on its axis, henceforth making each day a fraction of a second shorter than before. The quake, of magnitude 9.0, was the Earth's biggest in 40 years. It sent tsunamis-giant waves up to 10m high-crashing ashore in countries all around the Indian Ocean, sweeping away people and buildings. On Thursday the worldwide death toll from the tsunamis soared to above 120,000 after Indonesia said that huge numbers of further casualties had been discovered in the separatist-torn province of Aceh, on the northern tip of Sumatra and nearest the quake's epicentre. The death toll in Sumatra alone is now put at 80,000 and Indonesia says perhaps another 20,000 bodies remain to be discovered in remote parts of the island.

"The Race to Aid the Tsunami Survivors" also serves as a call to action, reminding us that the tragedy of death will be compounded unless we quickly turn our attention to a more pressing matter: the survivors.

Thousands, perhaps millions who somehow survived the wall of water that came crashing down on them now face death from disease, hunger and starvation. The disaster has wiped out sanitation, food and drinking-water supplies, and other vital services in the worst-affected regions. In places like Thailand's Khao Lak tourist beach, where thousands died, the stench of rotting flesh is unmistakable and each tide brings more bloated corpses. The UN's World Health Organisation says the tsunamis have left up to 5m people without the basics for survival. In Sri Lanka alone, around 1.5m have lost their homes.

What can economics teach us about how best to address the needs of survivors of this, and future, natural disasters? Fortunately, a great deal. Economics is, after all, the study of how we deal with scarcity - scarcity made starkly real by events like the Indian Ocean tsunami. The concepts and principles we learn in relative comfort are no less true in times of distress. Economics teaches us that the quality of people's lives depends, ultimately, on the production and distribution of goods and services. And like it or not, the laws of supply and demand that govern this process are as binding in times of crisis as they are in times of plenty.

Talking Points: Short-Run Issues: Helping the Survivors

1. It's easy to feel helpless in the face of the sheer magnitude of the devastation in Asia. At the same time, the urge to "do something" can be overwhelming and frustrating. Discuss the merits (and drawbacks) of you, individually, taking each of the following actions.

   1. Donate money to the Red Cross, Red Crescent or similarly reputable relief agency.

   2. Schedule a trip with your friends to stay on the beaches in Thailand over spring break.

   3. Travel to Indonesia as a relief volunteer.

   4. Purchase and send goods such as water, diapers, medicines and plastic tarps.

   There is no "perfect" action; each alternative listed above can be beneficial to some degree. However, economic reasoning and our understanding of demand, supply, and markets, teaches us that some actions are likely to be more effective than others.

   1. Donating money seems an impersonal response to a situation that, because of the immediacy of media coverage, often feels very personal to us. Nonetheless, we should not let our feelings obscure what we know - that money commands goods and services. It may not make us feel as good to send money as it would to actually "do something," but for most of us, it's much more effective. Donating money allows relief agencies to quickly purchase and ship the items that are needed in the devastated nations ringing the Indian Ocean.

   2. Booking your spring break may sound frivolous at first, but think again. Don't overlook the importance of this response to places like Thailand and the Maldives, which are heavily dependent upon the tourist industry. In fact, within days after the tidal wave, businesses in these areas were encouraging tourists to return. The Thai resort town of Phuket is posting daily updated pictures of resorts and beaches, assuring tourists that clean-up and reconstruction are progressing rapidly and Phuket is open for business.
      http://www.phuket-photos.com/frameme.php?page=phuket-tidal-wave.htm

      The more quickly tourists return, the more quickly people in the area will regain their sources of income. Your scheduled trip may also help to convince investors of the wisdom of financing resort repairs, and will let travel agents and other travelers know tourists are welcome.

      After the 1989 San Francisco earthquake many shops and restaurants went out of business because the tourists stopped coming. If tourism does not quickly resume in Indian Ocean resort areas, the natural disaster could be compounded by an aggravated economic slowdown, making a short-run issue into a long-run problem.

      (And, as an added bonus, your willingness to be one of the first to return may get you a great price!)

   3. Certainly your desire to work and share in the discomforts is commendable, and your labor is valuable, especially if you have a needed skill (doctor, nurse, paramedic, contractor, heavy equipment operator, etc.) And, like tourists, volunteers bring money with them, creating demand for goods and services that further stimulates markets to increase supply.

      One thing to consider, however, is whether your presence would be a benefit or a burden. Are you connected with an organization that can help to coordinate your travel, food, lodging and the supplies to support your efforts, for example? Have you considered the possibility that by staying home and doing something you do really well, you could contribute more - in the form of money - than you could with your presence?

   4. Although donating goods may be our first impulse, it's actually not a very good option for most of us - as many of the international relief organizations are quick to point out. It's difficult for us to know what is needed and it is also difficult to handle transportation and distribution.

      Before discussing option D, ask students to generate a list:
      What do you think are the primary short-run needs of people in the tsunami-affected areas?
      
      This should generate a laundry list of items, some of which - like drinking water - will be right on the mark. Others will be too vague to be useful. "Food," for example. What kind of food? How much? Are there things people will NOT eat because of religious or cultural norms? "Medicine." Again, what types and how much?

      Finally, point out to students that they overlooked some items that are sorely needed or have actually been used, but are not on their lists.

      • Kerosene - to assist in the disposal of corpses
      • Ice - to prevent food spoilage
      • Plastic sheets - Many of those who lost housing suffered greatly when the sunny tsunami day was followed by torrential rains.
      • Chain saws
      • Water purifiers
      • Elephants and mahouts (elephant drivers) to move toppled buildings and carry supplies over damaged roads.

   Sometimes people's desire to help actually creates new problems. It's not uncommon, for example, that in the days immediately after a disaster, relief agencies are flooded by donations of old clothes. In the aftermath of the 9/11 attacks, the city of New York was burdened by warehouses full of teddy bears, pet food and other articles testifying to the fact that good intentions aren't the most reliable source of information about what is actually needed and wanted in a crisis.

2. What do you suppose will happen to the prices of clean water and non-perishable food in areas hit by natural disasters? How will markets respond? Will the price changes help or hurt the relief and recovery efforts?

   During times of disaster basic necessities such as clean water and non-perishable food become more relatively scarce, usually because supply sources are destroyed or disabled. As a result, prices rise. The higher prices provide a profit opportunity that induces additional suppliers to rush in the needed goods.

   While higher prices would seem to impose further hardship on people in crisis, we must realize, objectively, that they perform an important function in encouraging people to conserve water and food. It's true that those higher prices are another hardship for people dispossessed or out of work because of the disaster - but that's where the money you donatedcomes in. The higher prices encourage suppliers to make food and water available for purchase. People's donations enable the relief agencies to pay the prices of food and water, which they then donate to the survivors.

3. Many times during natural disasters, the rising prices of goods and services are seen as an opportunistic or dishonest response on the part of sellers. Suppose the governments of the Indian Ocean countries inundated by the tsunami issue decrees freezing the prices of water and food in affected areas? Predict the likely impact.

   Freezing prices will reduce supply responses, undercutting the incentives to deliver the additional supplies that would appear if prices were allowed to rise. Frozen prices create and aggravate shortages, as suppliers choose to sell their products elsewhere. When prices can't rise above opportunity costs, there is little incentive to provide goods for sale or for sellers to re-direct goods and services to affected markets. Transportation, distribution and the other costs associated with production have risen because of the disaster. Prices of the goods they sell must rise accordingly to overcome suppliers' opportunity costs.

   On the consumer side, low prices would do nothing to encourage people to conserve or cut back on consumption. Instead, they would encourage hoarding and an increase in black market activity.

   The October, 2004, Hot Topic: After the Hurricane: How Much Is Too Much? contains a more detailed discussion of the impact of price controls in the wake of a natural disaster.

4. Wouldn't it be better for the governments of affected countries take over their economies instead of leaving them to the unregulated operation of markets?

   The greatest problem that international aid agencies face in helping affected countries recover from the tsunami is getting the necessities of life to people in stricken areas. These vital goods and services can be provided by the market or they can be provided by government. But don't forget that governments, too, face the reality of scarcity. If they provide goods and services publicly, they cannot use their limited resources elsewhere. On the other hand, if goods and services are provided by the market, the resources of government and aid agencies are freed to address other needs. To the extent that markets can function in the aftermath of the crisis, the burden on government, relief, and aid agencies will be reduced.

5. What is the impact of foreign aid?

   Foreign monetary aid really is one of the best remedies during times of disaster - for the same reason that individual charitable donations are important, but on a larger scale: Goods and services flow to where the money is. Foreign monetary aid makes it possible for the magic of markets to solve the most basic problems associated with disaster-induced shortages of clean water, food, and housing. (An important caveat here is that the rule of law must be in place in the receiving country, so that foreign aid is used as intended and not high-jacked by corruption in government.)

   If we want more of something, we will have to pay increasingly higher prices to get it. Foreign aid - whether private or government sponsored - makes it possible to pay the higher prices.

   It is particularly important in this discussion to emphasize that markets rely on the willingness and ability of people to pay for goods and services. Following a natural disaster people may very well be willing to pay the higher costs of goods and services, but may not have the means to do so. Donations and foreign aid step into the breach.

6. Uncomfortable Question: Relief agencies worldwide are ramping up to provide aid to areas affected by the tsunami. The coordination and logistics of this effort will take time to organize; the United Nations expects it to take two to three weeks for its operations to be fully functional. Since air transport is limited and airlifting food and supplies will take public agencies weeks to amass, what would be the effect of dropping bundles of money on remote villages and then informing markets? (Assume that the rule of law is still relatively intact, so that people who find the money will be able to keep and spend it and not fear being mugged or murdered.)

   The knowledge that remote villages had large amounts of cash may provide entrepreneurs the incentive to enter the market place in an effort to capture the profits available by providing goods and services to remote villages. Since the ability of governments is limited, such an action may increase the speed at which supplies reach outlying areas.

Talking Points: Long-Run Issues: Rebuilding Economies

The long-run issues associated with the Asian natural disaster revolve around the damage to the economies of the tsunami-inundated regions. Devastation in Sri Lanka led the country's government to quickly declare a national emergency. The Economist reports (in its December 29th edition) that estimated damage in Thailand - certainly nowhere near the hardest hit country - may be as much as 0.36% of the country's 2003 GDP. The Indonesian government hasn't been able to get into many remote regions, let alone assess total damage. The long-term goal, then, must be to restore the productive capacity of affected areas so that they can provide for themselves and no longer need outside aid. While the reconstruction will take time, and the cost will likely amount to billions of dollars, there is some reason to be think that initial estimates of rebuilding time were overly pessimistic.

News footage shows that clean-up is progressing even in the midst of rescue operations. Look carefully at the pictures and you'll see that much existing infrastructure is intact. Buildings have collapsed or washed away, but foundations remain, for example. Water treatment plants were inundated and mechanisms damaged, but not destroyed. The good news is that repairing infrastructure is easier, quicker, and cheaper than creating it anew. The importance of infrastructure and other capital will become clear as the Asian nations begin the process of restoring productivity in tsunami-affected regions.

1. Natural disasters are the opposite of economic growth. They have the effect of shifting the production possibilities frontier curve (PPF) inward, toward the origin. In other words, the ability of the country to produce all goods and services is reduced. The size and persistence of the diminished ability to produce depends on the nature of damage done.

   Begin with a simple PPF illustration, and use it to help you answer the questions below.

   A. Suppose that in one region the tsunami does major damage to existing capital and in another does relatively little damage to existing capital. Compare the impact on output and economic growth in the two areas.

   Production is, in the simplest case, the process of labor and capital turning natural resources into goods and services. Capital makes labor more productive (think how hard it would be to produce without buildings, machines, and tools), so the areas in which capital was not destroyed should quickly return to pre-disaster levels, while those without capital will struggle for a longer time. Capital will have to be replaced before the region can return to full productivity.

   

   

   B. Focusing on the role of capital should not be taken to ignore the impact - both human and economic - of the thousands and thousands of lives lost. Besides the heart-wrenching loss to families and loved ones, the tsunami-affected areas have also lost significant labor resources. How does the loss of labor affect a region's ability to produce? Is the effect different than or the same as the effect of losing capital? Explain.

   Massive loss of human life affects production and production possibilities in the same way as the loss of capital in that both contribute to the inward movement of the PPF on the graph. Unlike capital, however, labor cannot simply be repaired or replaced. Your discussion of this problem can expand to include such issues as migration, skilled v. unskilled labor, the impact on families, social unrest, etc.

2. Many developing nations rely on foreign direct investment (in which foreign-owned companies build and operate their businesses and factories in the developing country) to stimulate their economies and contribute to economic growth. Economic growth has been the cause of recent reductions in worldwide poverty. How might this disaster affect foreign direct investment and economic growth?

   The reduced productive capability illustrated by the inward movement of the PPF may be further compounded if entrepreneurs and investors perceive that the tsunami has made the area more risky for investment. The change in perceived risk could come from nervousness about future natural disasters, but is more likely to result from fear that profit flows will be affected by perceptions of consumers worldwide. This risk is especially important for countries with large tourist industries. Investors may clearly understand that tsunami is an infrequent event that does not affect long term risk, but if tourists become unwilling to travel to the area, no level of physical security will make up for the lack of visitors.

   It's important to note that overall, economists would not expect that the Asian tsunami will permanently derail the growth of the region. The institutional characteristics of the affected nations are much more important to their long term economic growth than an infrequent natural disaster - despite its alarming magnitude.

3. Uncomfortable Question: During the Middle Ages, the Black Plague eliminated up to one third of the population of Europe. One of the documented effects of this reduction in population was a marked increase in the real wages of the survivors. Economists explain this by noting that the amount of capital (buildings, machines, and tools) per worker and the amount of land and natural resources per worker increased. A worker using capital is able to add more to production than one without; he has a higher marginal product of labor. And since more productive workers command higher wages, those who survived the Black Plague experienced notable increases in their wages. How is an event like the Black Plague different from a natural disaster? What do you expect the effect of the Asian tsunami to be on the wages of the survivors in the long-run?

   The Black Plague differs from a natural disaster in that the plague only destroyed labor resources, not capital. As a result, the surviving labor had more capital (per capita) to use in the productive process. Natural disasters tend to damage and destroy capital as well as destroying labor, so the impact on the capital/labor ratio is much more difficult to foresee. At this time, we don't know about the capital/labor effects of the tsunami, but we can identify three possibilities.

   1. If more capital was destroyed than labor, the real wage will fall in the short run. (Wage recovery in the long-run will depend on the capital being replaced.)

   2. If labor and capital were destroyed in equal shares, the real wage will remain unchanged. (If, however, the existing capital is replaced and labor is not, the real wage may rise as the capital stock recovers.)

   3. If more labor was destroyed than capital, the real wages will rise as they did after the Plague, but this is unlikely. Although thousands of people died, relative to the total stock of labor, the number is small. Additionally, and sadly, estimates suggest that children comprise 40% or more of the fatalities, further reducing the current labor force impact of the tsunami.

   Although we can't be sure without further data, it's likely that the Asian situation is best described by A above, and is not comparable to the experience of Europe in the Middle Ages. The very real possibility that people already impoverished by the tsunami will face lower wages as they struggle to recover highlights the importance of aid efforts to repair and rebuild capital in order to begin restoring productivity and economic growth.