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Inertia Risk: Improving Economic Models of Catastrophes

Crépin, A.-S., and E. Nævdal. 2019. Scandinavian Journal of Economics doi: 10.1111/sjoe.12381

Abstract:

We model endogenous catastrophic risk in a new way we term inertia risk, which accounts for delays between physical variables and the hazard rate—a characteristic often observed in reality. The added realism significantly impacts optimal policies relative to the standard model of catastrophic risk. The probability of a catastrophe occurring at some point in time may span the entire interval [0, 1] and is not 0 or 1 as is typical in standard models. Inertia risk may also generate path dependencies. We illustrate the implications for policy in a simple model of climate change.

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Keywords: Catastrophic risk, climate change, lagged effects, resource management

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