Lack of preparation for rare events

Abstract

A new view of crises is proposed: A rare event occurs, consciously unprepared agents take bad actions, and catastrophic consequences follow. We model agents who prepare to act in different contingencies. They can process only a finite amount of information and thus cannot prepare perfectly for all contingencies. In equilibrium, agents equate the probability-weighted expected loss due to suboptimal action across contingencies, implying that the expected loss in a rare event is orders of magnitude larger than in normal times. Limited liability causes even less preparation for rare events and creates inefficiencies.