Uncertainty is the Friend of Delay

by on January 1, 2007 at 7:21 am in Economics | Permalink

Regarding global warming and what to do about it, Brad DeLong approvingly paraphrases Tyler, "uncertainty is not the friend of doing nothing."  Bearing in mind the obvious dangers of contradicting both Brad and Tyler let me counter with "uncertainty is the friend of delay."

If you are faced with two environments one of which has outcomes somewhere between -10 to 10 and the other somewhere between -100 to 100 then I agree that the greater uncertainty of the latter provides no necessary reason for doing less relative to the former. 

Suppose, however, that we are uncertain about which environment we are in but the uncertainty will resolve over time.  In this case, there is a strong argument for delay.  The argument comes from option pricing theory applied to real options.  A potential decision is like an option, making the decision is like exercising the option.  Uncertainty raises the value of any option which means that the more uncertainty the more we should hold on to the option, i.e. not exercise or delay our decision.

Imagine, for example, that there are 100 doors before us.  We can enter any door but once we enter it will be costly to exit.  If we don’t decide then over time we learn a little bit about what is behind each door.  If our uncertainty to begin with is small, we know that behind each door is more or less the same thing, then learning has little value and we should decide now (assuming some modest cost to waiting).  But if our uncertainty is large then learning has a lot of value and we should delay our decision until some of our uncertainty has been resolved.

Applying the theory to global warming isn’t easy because our decisions involve many options and exit costs but if we think that our knowledge of the extent, cost, cause and solutions to global warming are increasing at a faster rate than the danger of global warming then delay of any major decision is a rational policy at the present time.

 

Tyler Cowen January 1, 2007 at 8:30 am

I see the difference between us as such: you write: “making the decision is like exercising the option…”. But many costly decisions *increase* option value. Such decisions include more R&D, more savings, a compensation fund, investment in greater economic flexibility and response capabilities, and so on. Anything we do counts as a “decision,” so we cannot postpone decisions per se. We can and should postpone relatively irrevocable decisions, and under that heading “consumption” is a prime candidate. The correct implication of your argument is that when uncertainty increases, we should (under some specific conditions outlined in my post) consume less, which is close to my point of view.

Victor January 1, 2007 at 8:45 am

I agree on the difficulty in applying option theory to global warming policy. There’s a myriad options with varying cost/lead-time trade-offs. The uncertainties are considerable, have many dimensions, and the flow of information to resolve them is stochastic. But option theory doesn’t always argue for delay. If your doctor said there was a chance you had a flesh-eating bacterial infection that would take several days for the tests to resolve, would you delay or accept treatment? It’s a no-brainer if the treatment was just taking a bottle of antibiotics, but if your arm is turning red immediate hospitalization for intravenous antibiotics might be the optimum strategy. Acting now can preserve options going forward. At a simple level for communication, an insurance framing of the problem works better for me.

logicnazi January 1, 2007 at 1:37 pm

I second the objection that what to do about global warming is not irrevocable. Your argument supports a 5 year plan with sunset clauses not choosing the option (doing nothing is taking an option here) of doing nothing for the next five years.

Bill Gardner January 1, 2007 at 6:00 pm

I too agree with Victor. Part of what’s uncertain concerns how much non-linearity there is in climate change. If there is a lot of positive feedback in the warming process, then the flesh-eating bacterium analogy fits really well.

nick January 2, 2007 at 3:26 am

Even greater than the uncertainty of the global warming threat is the uncertainty in the threat posed by a potentially quite corrupt international bureaucracy with the power to regulate our most basic industries into obliviion.

As uncertain as our global warming science may be, an even more important learning task is reducing our genuinely vast uncertainty — political ideologues of any stripe with their pat solutions notwithstanding — of how to solve it without creating problems far worse still.

Bernard Yomtov January 2, 2007 at 8:03 pm

It is not really true that our options “expire†. They only become slightly more expensive, but certainly worth the wait since the probability that the global warming scare is exaggerated is large.

Once something irreversible happens, our option to take steps to prevent it has indeed expired.

Even if the strike price of our options merely increase, there is no basis for assuming that the increase will be slight.

Your analysis hinges on your belief that the scare is likely exaggerated. But this is more or less irrelevant to the point. The question is what to do in the face of uncertainty. If you know what the stock price is going to be it’s not hard to figure out what to do with an option.

ChrisA January 3, 2007 at 8:52 am

Mickslam you said

“If we are wrong about global warming, we end modern civilization within my childrens lifetime.” –

Where did you get that idea from? Using the Stern report’s numbers, which presumably are the latest view, the expected reduction in global GDP is 5% in the business as usual case, i.e. if we do nothing. They mention a downside case which (in my view) takes in some dodgy arguments on the value of social disruptions. Bit let’s use their numbers, I quote below:

“Putting these three additional factors together would increase the total cost of BAU climate change to the equivalent of around a 20% reduction in current per-capita consumption, now and forever. Distributional judgements, a concern with living standards beyond those elements reflected in GDP,and modern approaches to uncertainty all suggest that the appropriate estimate of damages may well lie in the upper part of the range 5 – 20%.”

Now given that average world GDP growth is around 3% (although recently it has been higher than that) we are talking about a worst case loss of 6 or 7 years world growth, bad but not disastrous. Remember that those future people experience this loss are going to be a lot richer than us anyway. In other words the worst case is that your great-grandchildren instead of being 19.2 times richer than you in 100 years will only be 16 times richer – not really a big problem I would guess.

I would think that, given the limited downside, the benefits of waiting to see if it is a real problem are very strong.

Mr. Econotarian January 3, 2007 at 12:13 pm

“this is a decade of completely flat growth across the entire planet”

Japan had a decade of flat growth and made it OK…

Perhaps if the poor countries of the world just economically liberated themselves, they could grow to a point where they could handle global warming.

Since these countries can’t even seem to manage the political will to do this, how are they going to get the political will to limit CO2 and methane emissions?

mickslam January 3, 2007 at 1:49 pm

“Japan had a decade of flat growth and made it OK…” With the rest of the world operating normally.

ChrisA,

I answered why your analysis is not relevant in my first post. Risk of ruin based analysis, not most likely scenario or best outcome style analysis, is the correct method by which to evaluate this particular situation. Note that our most successful traders (Warren Buffet, John Henry, George Soros), essentially our most successful capitalists, have used this style of analysis to generate massive long term profits. It is a superior style of analysis for situations where there is the chance of catastrophic loss.

If you are buying a car, use best outcome or most likely scenario analysis. If you are wrong, bad outcomes will only set you back a little. If you are betting your childrens life, use risk of ruin style. If you are betting your net worth, use risk of ruin style analysis.

I’ve seen few situations where the acutal worst case scenario that actually happens is that imagined by economists. Usually, they are wildly off and what happens has little relationship to what was predicted. For example, what happened in Russia after the fall was far worse than predicted. Today, it is a country run by mobsters who kill people they don’t like and imprision enemies and take their assets. Mobsters weren’t part of the economic prediction – the free markets were supposed to sort all of that out. This was a smooth transition, almost bloodless, but the life expectancy of Russians went down by about roughly years.

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r4i gold February 26, 2010 at 12:04 am

I feel like the biggest problem with applying option theoretic intuitions to climate change is the fact that strike is nonconstant; this expands on Victor’s point in Brad’s post. Climate change is like flesh-eating bacteria in that the costs you pay to fix the problem increase with time in some complicated way, because it’s harder to undo more emissions than fewer and because you’d rather be cured before your arm was eaten off than after, respectively. In either case, the argument that early option exercise is almost never optimal just doesn’t apply; you may well wish to call at $50 today if tomorrow’s strike will be $75.

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