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Why uncertainty matters - discounting under intertemporal risk aversion and ambiguity

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  • Traeger, Christian P.

Abstract

Uncertainty has an almost negligible impact on project value in the standardeconomic model. I show that a comprehensive evaluation of uncertainty and uncertainty attitude changes this picture fundamentally. The illustration of this result relies on the discount rate, which is the crucial determinant in balancing immediate costs againstfuture benefits, and the single most important determinant of optimal mitigation policies in the integrated assessment of climate change. First, the paper removes an implicit assumption of (intertemporal or intrinsic) risk neutrality from the standard economic model. Second, the paper introduces aversion to non-risk uncertainty (ambiguity). Ishow a close formal similarity between the model of intertemporal risk aversion, which is a reformulation of the widespread Epstein-Zin-Weil model, and a recent model of smooth ambiguity aversion. I merge the models, achieving a threefold disentanglement between, risk aversion, ambiguity aversion, and the propensity to smooth consumptionover time.

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Paper provided by Department of Agricultural & Resource Economics, UC Berkeley in its series Department of Agricultural & Resource Economics, UC Berkeley, Working Paper Series with number qt2w614303.

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Date of creation: 11 May 2012
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Handle: RePEc:cdl:agrebk:qt2w614303

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Keywords: ambiguity; climate change; cost benefit analysis; discounting; intertemporal substitutability; risk aversion; uncertainty; Social and Behavioral Sciences; Life Sciences;

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Citations

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Cited by:
  1. Iverson, Terrence, 2013. "Minimax regret discounting," Journal of Environmental Economics and Management, Elsevier, vol. 66(3), pages 598-608.
  2. Traeger, Christian, 2013. "A 4-stated DICE: quantitatively addressing uncertainty effects in climate change," Department of Agricultural & Resource Economics, UC Berkeley, Working Paper Series qt9034k05t, Department of Agricultural & Resource Economics, UC Berkeley.
  3. Svenja Hector, 2013. "Accounting for Different Uncertainties: Implications for Climate Investments?," Working Papers 2013.107, Fondazione Eni Enrico Mattei.
  4. Yongyang Cai & Kenneth L. Judd & Thomas S. Lontzek, 2013. "The Social Cost of Stochastic and Irreversible Climate Change," NBER Working Papers 18704, National Bureau of Economic Research, Inc.
  5. Larry S. Karp, 2012. "Provision of a Public Good with Altruistic Overlapping Generations and Many Tribes," CESifo Working Paper Series 3895, CESifo Group Munich.
  6. Traeger, Christian, 2012. "A 4-stated DICE: quantitatively addressing uncertainty effects in climate change," Department of Agricultural & Resource Economics, UC Berkeley, Working Paper Series qt6jx2p7fv, Department of Agricultural & Resource Economics, UC Berkeley.
  7. Crost, Benjamin & Traeger, Christian P., 2013. "Optimal climate policy: Uncertainty versus Monte Carlo," Economics Letters, Elsevier, vol. 120(3), pages 552-558.
  8. Svenja Hector(), . "Accounting for Different Uncertainties: Implications for Climate Investments?," Working Papers ETH-RC-13-007, ETH Zurich, Chair of Systems Design.

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