Fat Tails, Thin Tails, and Climate Change Policy

Robert Pindyck

No 16353, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Climate policy is complicated by the considerable compounded uncertainties over the costs and benefits of abatement. We don't even know the probability distributions for future temperatures and impacts, making cost-benefit analysis based on expected values challenging to say the least. There are good reasons to think that those probability distributions are fat-tailed, which implies that if social welfare is based on the expectation of a CRRA utility function, we should be willing to sacrifice close to 100% of GDP to reduce GHG emissions. I argue that unbounded marginal utility makes little sense, and once we put a bound on marginal utility, this implication of fat tails goes away: Expected marginal utility will be finite even if the distribution for outcomes is fat-tailed. Furthermore, depending on the bound on marginal utility, the index of risk aversion, and the damage function, a thin-tailed distribution can yield a higher expected marginal utility (and thus a greater willingness to pay for abatement) than a fat-tailed one.

JEL-codes: D81 Q51 Q54 (search for similar items in EconPapers)
Date: 2010-09
Note: EEE IO PE
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (12)

Published as Robert S. Pindyck, 2011. "Fat Tails, Thin Tails, and Climate Change Policy," Review of Environmental Economics and Policy, Oxford University Press for Association of Environmental and Resource Economists, vol. 5(2), pages 258-274, Summer.

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Journal Article: Fat Tails, Thin Tails, and Climate Change Policy (2011)
Working Paper: Fat Tails, Thin Tails, and Climate Change Policy (2010)
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