Economic Impacts of Disasters Taking into Account the Costs of Substitution of Intermediate Goods Kazuyoshi Nakano Graduate School of Informatics Kyoto University Uji, Japan nakano@imdr.dpri.kyoto-u.ac.jp Hirokazu Tatano Disaster Prevention Research Institute Kyoto University Uji, Japan tatano@imdr.dpri.kyoto-u.ac.jp Abstract—This paper focuses on the cost of substitution of intermediate goods and investigates how it affects macroeco- nomic dynamics after a natural disaster. This paper developes a macroeconomic model to show that the cost of substitution of intermediate goods is an important factor for expanding economic loss by inducing the ”cascade effect.” In addition, it illustrated that the cost of substitution can affect not only the amount of economic loss but also economic recovery speed. Index Terms—Natural disaster, Economic impact, Cost of substitution, Cascade effect I. I NTRODUCTION There have been a lot of efforts to develop regional eco- nomic models for estimation of economic impacts of natural disasters in the last decades (e.g. [1][2][3][4]). These literature mainly focused on short-term impacts, like lifeline disruption. On the other hand, many empirical surveys of natural disasters have pointed out that the negative impact on the GDP is not large when the reconstruction process is taken into account (e.g.[5][6][7]). However, in reality, capital inflow from other regions for the reconstruction of capital stock can induce an increase in the amount of external debt. It can affect the economy negatively in the long run, even after the flow of the economy (GDP) recovers. Therefore, in order to measure the economic impact as a whole, the reconstruction process and its long term effect should be investigated by taking into account the effect of external debt. Nakano and Tatano [8] developed a dynamic macroeconomic model to illustrate that household consumption decreases in the long run due to an increase in external debt caused by a sudden disaster. In addition, Nakano and Tatano [8] pointed out that the ”cascade effect” is a crutial component of the economic losses of natural disasters, and they modeled the cascade effect. However, they [8] did not clarify what factors induce the cascade effect. This paper shows that one of the factors involved in the cascade effect is the cost of substitution of intermediate goods, which is one of the main aims of this paper. If an intermediate goods sector is damaged, the supply of intermediate goods decreases, which can affect production in the final goods sectors. This relationship is called the ”cascade effect.” If firms can import substitutable intermediate goods alternatively from outside the affected region, the effect would be reduced. Therefore, the cost of substitution of intermediate goods is an important factor in examining the cascade effect. In addition, this paper explains that the cost of substitution of intermediate goods can affect not only the amount of eco- nomic loss but also the economic recovery process. This paper focuses on the following structure. If the cost of substitution of intermediate goods is high, then economic loss will increase as a result of the cascade effect. In this case, the incentive for recovery would be high. On the other hand, if the cost of substitution is low, the cascade effect will not be induced. In this case, the incentive for recovery would be relatively low. Thus, the recovery process is also affected by the cost of substitution of intermediate goods. This paper is organized as follows. In Section 2, we discuss a basic dynamic macroeconomic model that is an extension of Nakano and Tatano [8]. In Section 3, the economic growth path before a disaster. Section 4 investigates the economic impact of a disaster is considered. Two cases are compared so as to demonstrate the effect that the cost of substitutution has on both economic loss and economic recovery speed. In section 5, we summarize the results of this paper. II. THE MODEL A. Basic Concept This paper focuses on the cost for obtaining substitutable intermediate goods from outside the affected region in the aftermath of natural disasters. If a firm producing intermediate goods is damaged as a result of a disaster, the firms in the final goods sector may start to import the substitutable intermediate goods from outside the affected regions to prevent production rates from falling. It might cause an increase of cost for obtaining intermediate goods because it would be necessary for the firms in the final goods sector to adjust some operation processes so as to adopt the new products. On the other hand, the affected firms in intermediate goods sector may make effort to provide their products by expanding the production of factories outside the affected region or by borrowing the facilities from companies outside the affected region. It might cause an increase of cost for production of the affected firm in the intermediate good sector because it would be necessary to transfer technology from the affected factories. These means that the price of intermediate goods, which are made available Proceedings of the 2009 IEEE International Conference on Systems, Man, and Cybernetics San Antonio, TX, USA - October 2009 978-1-4244-2794-9/09/$25.00 ©2009 IEEE 1116