Expected Utility and Catastrophic Risk in a Stochastic Economy-Climate Model
CentER Discussion Paper Series No. 2010-122
42 Pages Posted: 5 Dec 2010
Date Written: November 26, 2010
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 utility with constant relative risk aversion (power utility); statisticians typically 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.
Keywords: Economy-climate models, Catastrophe, Expected utility, Heavy tails, Power utility
JEL Classification: D81, Q5
Suggested Citation: Suggested Citation