Weitzman Meets Nordhaus: Expected Utility and Catastrophic Risk in a Stochastic Economy-Climate Model

36 Pages Posted: 20 Dec 2011

See all articles by Masako Ikefuji

Masako Ikefuji

University of Tsukuba

Roger J. A. Laeven

University of Amsterdam - Department of Quantitative Economics (KE)

J.R. Magnus

Vrije Universiteit Amsterdam, School of Business and Economics

Chris Muris

affiliation not provided to SSRN

Date Written: December 15, 2011

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.

Keywords: economy-climate models, catastrophe, expected utility, heavytails, power utility

JEL Classification: D61, D81, Q5

Suggested Citation

Ikefuji, Masako and Laeven, Roger Jean Auguste and Magnus, Jan R. and Muris, Chris, Weitzman Meets Nordhaus: Expected Utility and Catastrophic Risk in a Stochastic Economy-Climate Model (December 15, 2011). ISER Discussion Paper No. 825. Available at SSRN: https://ssrn.com/abstract=1974333 or http://dx.doi.org/10.2139/ssrn.1974333

Masako Ikefuji

University of Tsukuba ( email )

Tsukuba University , Ibaraki Ken
Tsukuba, Ibaraki 305-8573, Ibaraki 3050006
Japan

Roger Jean Auguste Laeven (Contact Author)

University of Amsterdam - Department of Quantitative Economics (KE) ( email )

Valckenierstraat 65-67
Amsterdam, 1018 XE
Netherlands
+31 20 525 4252 (Phone)

HOME PAGE: http://www.rogerlaeven.com

Jan R. Magnus

Vrije Universiteit Amsterdam, School of Business and Economics ( email )

De Boelelaan 1105
Amsterdam, 1081HV
Netherlands

Chris Muris

affiliation not provided to SSRN ( email )

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