Irrational Economist_ Making Decisions in a Dangerous World - Erwann Michel-Kerjan [106]
The state-of-the-art methodology is to use either (1) an expected utility approach with an appropriate degree of risk aversion to compute certainty-equivalent benefits of preventive actions or (2) an asset pricing model from the theory of finance. The latter should be combined with the use of option values attached to more flexible dynamic strategies. However, this general methodology fails to take into account important aspects of certain economic problems, as I explain now.
Ambiguous Benefits, Small Probability Events, and the Precautionary Principle
It is difficult to assess the precise probability distribution to describe the uncertainty faced by decision makers who are dealing with environmental policies such as those associated with global warming or genetically modified organisms. The problem of imprecise probability is particularly crucial with respect to very unlikely events, whereby the speed with which one can learn from the empirical frequency is low. We must recognize that, because people are ambiguity averse, the ambiguity on the distribution of impacts has an adverse effect on social welfare. What are the consequences of ambiguity aversion on the optimal investment in prevention? The general idea is that ambiguity aversion reinforces risk aversion, rendering people more reluctant to undergo ambiguous risky acts. The same idea can be found in the debate about the precautionary principle. This principle has been discussed in various international forums, including the Conference of Rio on Environment and Development and the Maastricht Treaty. It states that “lack of full scientific certainty shall not be used as a reason for postponing cost-effective measures to prevent environmental degradation.” Indeed, the precautionary principle has widely been interpreted as a recommendation for reducing collective risk exposure in the presence of ambiguous probabilities. In short, ambiguity aversion should make us behave in a more precautionary way.
The Value of Flexibility, the Debate Between Mitigation and Adaptation, and the Energy Problem
In a risky environment, new information usually generates new decisions. Furthermore, what can or cannot be done ex post affects the optimal action ex ante. In the context of climate change, there is an important debate emerging on the interaction between mitigation of global changes (limiting the emissions of greenhouse gases) and adaptation to them (preparing to deal with the effects of global warming). The optimal mitigation strategy depends on our beliefs about society’s ability to adapt to changes in its environment. Moreover, new information about the intensity of the impacts of climate change, and about the availability of cheap technologies to limit emissions, affects the optimal mitigation strategy—and this flexibility should be taken into account as we determine our optimal effort today.
The emergence of the energy question in the public debate and the reduction of the stock of nonrenewable resources raise similar policy questions. How fast can/should we extract this resource, if we don’t know the total amount of resource available? The same question applies when the evolution of the cost of renewable energy sources is stochastic (Dasgupta and Stiglitz, 1971).
What is the effect of flexibility on the optimal risk attitude? One needs to compare the choices under risk in two different contexts. In the flexible context, the decision maker first selects a risk position in a choice set and then, after observing the risk outcome, takes an action. In the rigid context, the agent must commit to an action before observing the state of nature. Intuition suggests that the agent should be more risk-prone in the flexible context than in the rigid one. This point is related to the irreversibility effect and real option values first developed by