Irrational Economist_ Making Decisions in a Dangerous World - Erwann Michel-Kerjan [107]
The value of flexibility and its effects on collective risk attitude are often overlooked in environmental economics. For example, in the Stern Review, it is implicitly assumed that all decisions about the mitigation of climate change should be made immediately. I suggest that one should instead approach the climate change problem and the energy problem by solving them via stochastic dynamic calculus, as in continuous-time finance with predictable assets returns. (This approach was developed in 1969 by American economists and Nobel Laureates Robert Merton and Paul Samuelson.) There are indeed clear links to the literature of dynamic finance: (1) Preserving a nonrenewable resource, or reducing emission of CO2 under a constraint of maximum concentration, is equivalent to an increase in saving; (2) the uncertainty about the stock of the resource, or the uncertainty about the desirable maximum concentration of CO2, is parallel to income uncertainty in the standard consumption-portfolio problem; (3) emitting greenhouse gases when the environmental impact is uncertain is equivalent to investing in a risky asset. However, an important difference is due to the absence of an objective probability distribution for the impacts of climate change, or for the speed of technological progress.
Economics and the Psychology of the Precautionary Principle
The normative theory of the efficiency of long-term environmental risks is based on standard assumptions: expected utility (possibly generalized to smooth ambiguity aversion), rational expectation, and exponential discounting of future felicity. This theory has a strong normative basis (e.g., the independence axiom) but a relatively weak positive power to predict real behaviors. Recent developments at the frontier between psychology and economics have revealed that people often evaluate, behave, and judge other agents’ decisions under uncertainty in a different way than predicted by the standard theory.
An important aspect of the political economy of the precautionary principle is related to the way people evaluate and judge ex ante collective decisions after new information is obtained about the risk. From a normative point of view, information not available at the time of the decision should be irrelevant to evaluation of the optimality of the initial decision in the face of uncertainty. In reality, people have difficulty behaving in that way. For example, they usually feel regret. Regret is a psychological reaction to making a wrong decision, where the quality of decision is predicated on the basis of actual outcomes rather than on the information available at the time of the decision. How does the aversion to regret affect the optimal level of prevention of a future risk? How do people weight the two types of regret/error? In other words, do they (1) invest a lot in the reduction of CO2 emissions before learning that the economy can easily adapt to climate changes, or (2) avoid doing anything in terms of mitigation before learning that the economy is badly hit by the increased temperature? And how do public decision makers react to the expectation that they will be judged by regret-sensitive agents?
Another promising direction of research is related to the formation of beliefs about long-term risks. If people have anticipatory feelings about the future, they may distort their beliefs in order to fight their anxiety. This willingness to bias beliefs is limited by the knowledge that too much optimism or wishful thinking yields bad risk management for the future. Economists want to explore an alternative explanation based on the fact that too much optimism ex ante increases the chance of disappointment ex post. We will characterize the optimal distortion of individual and collective beliefs, and the equilibrium collective level of prevention of the risk (as a function of the duration between the decision and the realization of the risk).
IN CLOSING
As more economists are asked to think about, and advise on, global long-term risks, these