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Weitzman meets Nordhaus: Expected utility and catastrophic risk in a stochastic economy-climate model

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  • Masako Ikefuji
  • Roger J. A. Laeven
  • Jan R. Magnus
  • Chris Muris

Abstract

We specify a stochastic economy-climate model, adapting Nordhaus' deterministic economy-climate model by allowing for Weitzman-type stochasticity. We show that, under expected power utility, the model is fragile to heavy-tailed distributional assumptions and we derive necessary and sufficient conditions on the utility function to avoid fragility. We solve our stochastic economy-climate model for two cases with compatible pairs of utility functions and heavy-tailed distributional assumptions. We further develop and implement a procedure to learn the input parameters of our model and show that the model thus specified produces robust optimal policies. The numerical results indicate that higher levels of uncertainty lead to less abatement and consumption, and to more investment.

Suggested Citation

  • Masako Ikefuji & Roger J. A. Laeven & Jan R. Magnus & Chris Muris, 2011. "Weitzman meets Nordhaus: Expected utility and catastrophic risk in a stochastic economy-climate model," ISER Discussion Paper 0825, Institute of Social and Economic Research, Osaka University.
  • Handle: RePEc:dpr:wpaper:0825
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    File URL: http://www.iser.osaka-u.ac.jp/library/dp/2011/DP0825.pdf
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    References listed on IDEAS

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    6. Geweke, John, 2001. "A note on some limitations of CRRA utility," Economics Letters, Elsevier, vol. 71(3), pages 341-345, June.
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    8. Robert J. Barro, 2009. "Rare Disasters, Asset Prices, and Welfare Costs," American Economic Review, American Economic Association, vol. 99(1), pages 243-264, March.
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    15. Alan Manne & Richard Richels, 1992. "Buying Greenhouse Insurance: The Economic Costs of CO2 Emission Limits," MIT Press Books, The MIT Press, edition 1, volume 1, number 026213280x, January.
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    Cited by:

    1. David Comerford, 2013. "A balance of questions: what can we ask of climate change economics?," ESE Discussion Papers 216, Edinburgh School of Economics, University of Edinburgh.
    2. Masako Ikefuji & Roger Laeven & Jan Magnus & Chris Muris, 2013. "Pareto utility," Theory and Decision, Springer, vol. 75(1), pages 43-57, July.

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