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Fat Tails, Thin Tails, and Climate Change Policy

  • Robert S. Pindyck

Climate policy is complicated by the considerable uncertainties concerning the benefits and costs of abatement. We do not even know the probability distributions for future temperatures and impacts, making benefit--cost analysis based on expected values challenging to say the least. There are good reasons to believe that those probability distributions are fat-tailed, which implies that if social welfare is based on the expectation of a constant relative risk aversion utility function, then we should be willing to sacrifice close to 100 percent of gross domestic product to reduce greenhouse gas emissions. I argue that unbounded marginal utility makes little sense and that once we put a bound on marginal utility, this implication of fat tails goes away: Expected marginal utility will be finite even if the distribution for outcomes is fat-tailed. Furthermore, depending on the bound on marginal utility, the index of risk aversion, and the damage function, a thin-tailed distribution can actually yield a higher expected marginal utility (and thus a greater willingness to pay for abatement) than a fat-tailed one. Copyright 2011, Oxford University Press.

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Article provided by Association of Environmental and Resource Economists in its journal Review of Environmental Economics and Policy.

Volume (Year): 5 (2011)
Issue (Month): 2 (Summer)
Pages: 258-274

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Handle: RePEc:oup:renvpo:v:5:y:2011:i:2:p:258-274
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  1. Pindyck, Robert S., 2002. "Optimal timing problems in environmental economics," Journal of Economic Dynamics and Control, Elsevier, vol. 26(9-10), pages 1677-1697, August.
  2. Robert S. Pindyck, 2010. "Modeling the Impact of Warming in Climate Change Economics," NBER Working Papers 15692, National Bureau of Economic Research, Inc.
  3. Robert S. Pindyck, 2009. "Uncertain Outcomes and Climate Change Policy," Working Papers 0907, Massachusetts Institute of Technology, Center for Energy and Environmental Policy Research.
  4. Adam Daigneault & Steve Newbold, 2009. "Climate Response Uncertainty and the Unexpected Benefits of Greenhouse Gas Emissions Reductions," NCEE Working Paper Series 200806, National Center for Environmental Economics, U.S. Environmental Protection Agency, revised Mar 2009.
  5. Robert S. Pindyck, 2009. "The Economic and Policy Consequences of Catastrophes," Working Papers 0912, Massachusetts Institute of Technology, Center for Energy and Environmental Policy Research.
  6. Geoffrey Heal & Bengt Kriström, 2002. "Uncertainty and Climate Change," Environmental & Resource Economics, European Association of Environmental and Resource Economists, vol. 22(1), pages 3-39, June.
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