### Abstract

Original language | English |
---|---|

Place of Publication | Tilburg |

Publisher | Econometrics |

Number of pages | 42 |

Volume | 2010-122 |

Publication status | Published - 2010 |

### Publication series

Name | CentER Discussion Paper |
---|---|

Volume | 2010-122 |

### Fingerprint

### Keywords

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

### Cite this

*Expected Utility and Catastrophic Risk in a Stochastic Economy-Climate Model*. (CentER Discussion Paper; Vol. 2010-122). Tilburg: Econometrics.

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**Expected Utility and Catastrophic Risk in a Stochastic Economy-Climate Model.** / Ikefuji, M.; Laeven, R.J.A.; Magnus, J.R.; Muris, C.H.M.

Research output: Working paper › Discussion paper › Other research output

TY - UNPB

T1 - Expected Utility and Catastrophic Risk in a Stochastic Economy-Climate Model

AU - Ikefuji, M.

AU - Laeven, R.J.A.

AU - Magnus, J.R.

AU - Muris, C.H.M.

N1 - Pagination: 42

PY - 2010

Y1 - 2010

N2 - 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.

AB - 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.

KW - Economy-climate models

KW - Catastrophe

KW - Expected utility

KW - Heavy tails

KW - Power utility

M3 - Discussion paper

VL - 2010-122

T3 - CentER Discussion Paper

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

PB - Econometrics

CY - Tilburg

ER -