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

Author

Listed:
  • Ikefuji, M.
  • Laeven, R.J.A.

    (Tilburg University, Center For Economic Research)

  • Magnus, J.R.

    (Tilburg University, Center For Economic Research)

  • 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.

Suggested Citation

  • Ikefuji, M. & Laeven, R.J.A. & Magnus, J.R. & Muris, C.H.M., 2010. "Expected Utility and Catastrophic Risk in a Stochastic Economy-Climate Model," Discussion Paper 2010-122, Tilburg University, Center for Economic Research.
  • Handle: RePEc:tiu:tiucen:52cbee73-e1dc-4ed3-8ec9-61bd0090c3da
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    References listed on IDEAS

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    Cited by:

    1. Ikefuji, M. & Laeven, R.J.A. & Magnus, J.R. & Muris, C.H.M., 2010. "Burr Utility," Discussion Paper 2010-81, Tilburg University, Center for Economic Research.
    2. Chanel, Olivier & Chichilnisky, Graciela, 2013. "Valuing life: Experimental evidence using sensitivity to rare events," Ecological Economics, Elsevier, vol. 85(C), pages 198-205.
    3. 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.
    4. Lucas Bretschger & Alexandra Vinogradova, 2014. "Growth and Mitigation Policies with Uncertain Climate Damage," CESifo Working Paper Series 5085, CESifo Group Munich.
    5. Bretschger, Lucas & Suphaphiphat, Nujin, 2014. "Effective climate policies in a dynamic North–South model," European Economic Review, Elsevier, vol. 69(C), pages 59-77.
    6. Buchholz, Wolfgang & Schymura, Michael, 2012. "Expected utility theory and the tyranny of catastrophic risks," Ecological Economics, Elsevier, vol. 77(C), pages 234-239.
    7. Hwang, In Chang & Tol, Richard S.J. & Hofkes, Marjan W., 2016. "Fat-tailed risk about climate change and climate policy," Energy Policy, Elsevier, vol. 89(C), pages 25-35.
    8. Grechuk, Bogdan & Zabarankin, Michael, 2014. "Risk averse decision making under catastrophic risk," European Journal of Operational Research, Elsevier, vol. 239(1), pages 166-176.
    9. 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.
    10. Rob Dellink & Thijs Dekker & Janina Ketterer, 2013. "The Fatter the Tail, the Fatter the Climate Agreement," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 56(2), pages 277-305, October.

    More about this item

    Keywords

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

    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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