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Fat Tails, Thin Tails, and Climate Change Policy

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  • Robert S. Pindyck

Abstract

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.

Suggested Citation

  • Robert S. Pindyck, 2011. "Fat Tails, Thin Tails, and Climate Change Policy," Review of Environmental Economics and Policy, Association of Environmental and Resource Economists, vol. 5(2), pages 258-274, Summer.
  • Handle: RePEc:oup:renvpo:v:5:y:2011:i:2:p:258-274
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    References listed on IDEAS

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    1. Robert S. Pindyck, 2011. "Modeling the Impact of Warming in Climate Change Economics," NBER Chapters, in: The Economics of Climate Change: Adaptations Past and Present, pages 47-71, National Bureau of Economic Research, Inc.
    2. 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.
    3. Pindyck, Robert S., 2012. "Uncertain outcomes and climate change policy," Journal of Environmental Economics and Management, Elsevier, vol. 63(3), pages 289-303.
    4. Robert S. Pindyck & Neng Wang, 2013. "The Economic and Policy Consequences of Catastrophes," American Economic Journal: Economic Policy, American Economic Association, vol. 5(4), pages 306-339, November.
    5. 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.
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    More about this item

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • Q51 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Valuation of Environmental Effects
    • Q54 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Climate; Natural Disasters and their Management; Global Warming

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