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Norwegian

Inertia in risk; improving economic models of catastrophes

Link to article:

[PDF]

Authors:

Crépin, Anne-Sophie, Eric Nævdal

Year:

2017

Reference:

CREE skrifter
Number in series: 2

Summary

We provide a new way to model endogenous catastrophic risk termed inertia risk, which accounts for dynamic lags between physical variables and the hazard rate—a characteristic which is often observed in real life problems. We show that the added realism in our risk model has intuitive appeal and significantly impacts optimal solutions. With inertia risk, the probability that a catastrophe will ever occur may span the entire interval [0, 1]. This as opposed to the standard approach where this probability is either zero or one. We also show how inertia risk may generate path dependency as the hazard rate depends on learning about how risk is distributed in state space. We illustrate the implications for policy in a simple model of climate change. The optimal solution with inertia depends on parameters, such as damage and discount rates in a qualitatively different way compared to the standard approach. Hence for problems with lagged effects, where inertia risk is a more realistic way to represent risk, using the standard models of catastrophic risk that discard these lagged effects could generate substantially flawed policy recommendations.

JEL:

C02; C61; Q20; Q54

Keywords:

Resource management, climate change, catastrophic risk, lagged effects

Project:

Oppdragsgiver: Norges forskningsråd
Oppdragsgivers prosjektnr.: 196199
Frisch prosjekt: 3172 - Managing Thresholds and Uncertainty in Resource Economics