Why uncertainty matters: discounting under intertemporal risk aversion and ambiguity

Abstract

Uncertainty has an almost negligible impact on project value in the standard economic model. I show that a comprehensive evaluation of uncertainty and uncertainty attitude changes this picture fundamentally. The illustration of this result relies on the discount rate, which is the crucial determinant in balancing immediate costs against future benefits, and the single most important determinant of optimal mitigation policies in the integrated assessment of climate change. First, the paper removes an implicit assumption of (intertemporal or intrinsic) risk neutrality from the standard economic model. Second, the paper introduces aversion to non-risk uncertainty (ambiguity). I show a close formal similarity between the model of intertemporal risk aversion, which is a reformulation of the widespread Epstein-Zin-Weil model, and a recent model of smooth ambiguity aversion. I merge the models, achieving a threefold disentanglement between, risk aversion, ambiguity aversion, and the propensity to smooth consumption over time.JEL Codes: D61, D81, D90, H43, Q00, Q54

How certain are we about the certainty-equivalent long term social discount rate?

“…Of course, the number of pdfs which share the basic information that de…nes the set is in…nite, and so there is signi…cant room left for disagreement. Yet, as we show, given some level of agreement on shared characteristics, the social planner can determine the highest and lowest certainty equivalent social discount rate that is consistent with the agreed set of pdfs, for each horizon H. In contrast to Iverson (2013) and Traeger (2014), therefore, our focus is on proving a range of potential values for R H which the social planner cannot easily dismiss, rather than determining a single precise schedule of discount rates for an ambiguity averse decision maker.…”

“…We are not alone in thinking this. Pindyck (2015) recently made a similar point in relation to social discounting, while Iverson (2013) and Traeger (2014) both take ambiguity as their starting points. Yet the approach that we take assumes far more knowledge about the future than Knight (1921), who would maintain that true uncertainty is immeasurable.…”

Discounting, beyond Utilitarianism

“…Another possibility to disentangle risk and equity preferences consists in using an alternative framework of dynamic choice proposed by Kreps and Porteus (1978), allowing a sequential resolution of uncertainty, as in the Epstein-Zin model of choice (Epstein and Zin, 1989). Several papers have investigated the consequences of such models for social discounting (Gollier, 2002;Traeger, 2014). One problem is that the Epstein-Zin model allows for non-monotonic preferences, which can lead to unfortunate conclusions (Chew and Epstein, 1990;Bommier and LeGrand, 2013).…”

Provision of a Public Good with Altruistic Overlapping Generations and Many Tribes

“…In a model that disentangles risk aversion from the elasticity of intertemporal substitution, stochastic growth might have little effect on the certainty equivalent discount rate (Traeger 2012b). Second, the assumption, adopted by most integrated assessment models (IAMs), that natural and man-made capital are highly substitutable, may be incorrect (Guersnerie 2004), (Hoel and Sterner 2007), (Traeger 2012a). Third, most IAMs, identify growth with increased GDP.…”