January 16, 2011

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

by M. Ikefuji, R.J.A. Laeven, J.R. Magnus and C.H.M. Muris

- 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.

Ikefuji, M., Laeven, R.J.A., Magnus, J.R. and Muris, C.H.M. (2010). "Expected Utility and Catastrophic Risk in a Stochastic Economy-Climate Model." CentER Discussion Paper No. 2010-122, Dec 2010.