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Expected Utility and Catastrophic Risk in a Stochastic Economy-Climate Model

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Author Info

  • Ikefuji, M.
  • Laeven, R.J.A.
  • Magnus, J.R.
  • Muris, C.H.M.

    (Tilburg University, Center for Economic Research)

Abstract

In the context of extreme climate change, we ask how to conduct expected utility analysis in the presence of catastrophic risks. Economists typically model decision making under risk and uncertainty by expected util- ity with constant relative risk aversion (power utility); statisticians typi- cally model economic catastrophes by probability distributions with heavy tails. Unfortunately, the expected utility framework is fragile with respect to heavy-tailed distributional assumptions. We specify a stochastic economy- climate model with power utility and explicitly demonstrate this fragility. We derive necessary and sufficient compatibility conditions on the utility function to avoid fragility and solve our stochastic economy-climate model for two examples of such compatible utility functions. We further develop and implement a procedure to learn the input parameters of our model and show that the model thus specified produces quite robust optimal policies. The numerical results indicate that higher levels of uncertainty (heavier tails) lead to less abatement and consumption, and to more investment, but this effect is not unlimited.

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Bibliographic Info

Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 2010-122.

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Date of creation: 2010
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Handle: RePEc:dgr:kubcen:2010122

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Web page: http://center.uvt.nl

Related research

Keywords: Economy-climate models; Catastrophe; Expected utility; Heavy tails; Power utility;

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Cited by:
  1. Hwang, In Chang & Reynès, Frédéric & Tol, Richard S. J., 2011. "Climate Policy Under Fat-Tailed Risk: An Application of Dice," Papers WP403, Economic and Social Research Institute (ESRI).
  2. Thijs Dekker & Rob Dellink & Janina Ketterer, 2013. "The Fatter the Tail, the Fatter the Climate Agreement - Simulating the Influence of Fat Tails in Climate Change Damages on the Success of International Climate Negotiations," CESifo Working Paper Series 4059, CESifo Group Munich.
  3. Olivier Chanel & Graciela Chichilnisky, 2011. "Valuing life: experimental evidence using sensitivity to rare events," Working Papers halshs-00651163, HAL.
  4. Lucas Bretschger & Alexandra Vinogradova, 2014. "Growth and Mitigation Policies with Uncertain Climate Damage," CEEES Paper Series CE3S-02/14, European University at St. Petersburg, Department of Economics.
  5. Rob Dellink & Thijs Dekker & Janina Ketterer, 2013. "The Fatter the Tail, the Fatter the Climate Agreement," Environmental & Resource Economics, European Association of Environmental and Resource Economists, vol. 56(2), pages 277-305, October.
  6. In Chang Hwang & Richard S.J. Tol & Marjan W. Hofkes, 2013. "Tail-effect and the Role of Greenhouse Gas Emissions Control," Working Paper Series 6613, Department of Economics, University of Sussex.

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