Expected Utility and Catastrophic Risk in a Stochastic Economy-Climate Model
AbstractIn 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 InfoPaper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 2010-122.
Date of creation: 2010
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Economy-climate models; Catastrophe; Expected utility; Heavy tails; Power utility;
Find related papers by JEL classification:
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- Q5 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics
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