Expected Utility Theory and the Tyranny of Catastrophic Risks

Expected Utility theory is not only applied to individual choices but also to social decisions, e.g. in cost-bene t analysis of climate change policy measures that a ect future generations and hence incorporate an ethical dimension. In this context the crucial question arises whether EU theory is able to deal with "catastrophic risks", i.e. risks of high, but very unlikely losses, in an ethically appealing way. In this paper we show that this is not the case. Rather, if in the framework of EU theory a plausible level of risk aversion is assumed, a "tyranny of catastrophic risk" (TCR) emerges, i.e. project evaluation may be dominated by the catastrophic event even if its probability is negligibly small. Or, contrary, with low degrees of risk aversion, the catastrophic risk eventually has no impact at all ("negligence of catastrophic risk" (NCR)) when its probability goes to zero which is ethically not acceptable as well.

Buchholz, Wolfgang and Michael Schymura (2012), Expected Utility Theory and the Tyranny of Catastrophic Risks, Ecological Economics 77 , 234-239