Tuesday, June 8, 2010

Benefit of abatement increases as ambiguity aversion increases!

A NBER working paper by Antony Millner, Simon Dietz, Geoffrey Heal

"Economic evaluation of climate policy traditionally treats uncertainty by appealing to expected utility theory. Yet our knowledge of the impacts of climate policy may not be sufficiently high quality to justify probabilistic beliefs. In such circumstances, it has been argued that the axioms of expected utility theory may not be the correct standard of rationality. Several axiomatic frameworks have recently been proposed to account for ambiguous beliefs. We apply static and dynamic versions of the smooth ambiguity model of Klibanoff et al, (2005, 2009) to climate policy. We illustrate via comparative statics the conditions under which an increase in ambiguity aversion increases the optimal level of mitigation in some simple examples. We then extend our analysis to a dynamic setting and adapt the well-known DICE model of the climate-economy system to show that the value of emissions abatement increases as ambiguity aversion increases. We also find that the value of abatement is more sensitive to risk aversion than to ambiguity aversion because, according to our data, the inter-model spread in average consumption growth is small relative to its mean value. However this is an empirical matter and we show that under some conditions ambiguity aversion can have a significant effect on the value of abatement."

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