When Financial Imperfections Are Not the Problem, But the Solution

The BP Deepwater Horizon oil spill of 2010 has focused considerable attention on the potential liability and the operating conduct of big oil companies. This paper shows that, limiting the ability of a company to insure and diversify its risks, creates incentives to internalize the welfare effects of catastrophic events, leading to a welfare improvement. We model an economy with complete financial markets where one agent’s actions impose an externality on other agents by altering the probability distribution of their risks. Then, a Pareto improved allocation can be reached via an asset reallocation, essentially restricting this agent’s choice of portfolio of assets. Hence, in the presence of externalities, disturbing the functioning of perfect financial markets can be socially beneficial.