How fast and to what extent should Australia cut its emissions? Agenda 14(3)
presented a Symposium on Climate Change that aired the existing division of
opinions. Some argued that we need to undertake large cuts now, while others
have been much more sceptical about the severity of the impacts that temperature
change might bring

Rodrigues-Neto, Jose

Agenda - A Journal of Policy Analysis and Reform

The Australian National University

Climate Change Policy: A Theorist’sPlea to Take Heed of Game Theory andAmbiguity AversionJosé A. Rodrigues-Neto1How fast and to what extent should Australia cut its emissions? Agenda 14(3)presented a Symposium on Climate Change that aired the existing division ofopinions.2  Some argued that we need to undertake large cuts now, while othershave been much more sceptical about the severity of the impacts that temperaturechange might bring. Despite such divisions, it would seem most analysts wouldsubscribe to the proposition that we need ‘to balance costs and benefits ofproposed policies’. Indeed, at present, the debate implicitly assumes that we canmake a straightforward cost-benefit analysis, the only potential problem beingthe one of obtaining good quantitative measures for the relevant variables.We argue that this view is incomplete, if not incorrect, and may bringdisastrous outcomes in one way or another. Here, we claim that the design ofoptimal policies may not be as simple as one would think at first glance.We contend that the discussion about the theoretical framework Australianeconomists are using to model climate-change-related policies has been greatlylacking. In this regard, we claim that decision theory and game theory shouldbe among the top priorities.Is it a good idea to use standard expected-utility theory to do a cost-benefitanalysis? We do not think so. If researchers choose to use theoretical modelsthat incorporate ambiguity aversion, as we suggest, the literature presents somealternatives.3 There are several questions that must be answered. For instance,how can we construct aggregate measures of risk and ambiguity aversionrepresenting all Australians? How much of public resources, if any, must thegovernment spend in order to protect us from the worst outcomes generated by1  School of Economics, College of Business and Economics, Australian National University,jose.neto@anu.edu.au. I would like to thank William Coleman and two anonymous referees for valuablecomments. All remaining mistakes are my own responsibility.2  See McKibbin (2007a) and (2007b); Quiggin (2007a) and (2007b); as well as Robson (2007a) and (2007b).3  Ellsberg (1961) presented a famous experiment in which most subjects act in violation of expected-utility theory’s predictions. The violation is sometimes explained by the existence of ambiguity aversion:that people prefer to bet (even if they have to pay a small premium) on an urn with 50 red and 50 blueballs, than in one with 100 balls but where the number of each colour is unknown. Ghirardato et al.(2004) and Marinacci (2000) have theoretic foundations for a decision theory and game theory that in-corporates ambiguity aversion. See Potamites and Zhang (2007), as well as Zhang (2007) and the referencesthere for empirical evidence suggesting that there is some positive degree of ambiguity aversion on thebehaviour of subjects in a controlled experiment, and for quantitative estimation of ambiguity aversionmeasures.85the lotteries associated with policies related to climate change? To try to answerthese we need to know first how much we will spend in research and whichareas need priority.Further, for each fixed proposed policy, how certain are we about theoutcomes that climate change may bring? As Knight (1921) taught us, there is asubtle but important difference between risk and uncertainty. The concept ofrisk is related to the fact that decision-makers obtain stochastic outcomes fortheir choices. For instance, when we flip a coin we do not know which side willcome up next, but we are pretty sure that each side has a 50 per cent chance ofcoming up. On the other hand, the idea of uncertainty suggests that there isless-than-perfect confidence over the probabilities associated with some actions.For instance, what is the probability that we will find ourselves in a catastrophicsituation 50 years from now if we do not cut emissions at all? One expert maysay it is ‘around 20 per cent’, while another, equally respected, scientist mayanswer that ‘it is at least 60 per cent’. Not only the consequences of ‘doingnothing’ are uncertain, but the mere assignment of probabilities to possibleoutcomes is a complicated task. As Weitzman (2007) explains in his critique ofthe famous Stern Review, when it comes to the assignment of discount rates inClimate Change models ‘uncertainty tends to matter much more than risk’.4This time scientists cannot rely on the expected-utility theory as usuallyapplied by economists because the challenges ahead of us involve a considerableamount of risk and uncertainty and also complex strategic considerations. Wedo not know every possible scenario that may happen. Even if we could listthem all, we still would not know the real probabilities associated with eachpossible policy. Any estimate would be just a guess because natural scientistsstill work in many open problems. Besides, there is also a large source ofuncertainty associated with other countries’ policies. Even if we knew exactlyhow pollution outcomes were translated into temperature changes, we wouldstill not understand how seriously other governments would deal with the issue,or how cooperative they would be. After all, typically politicians play to theirown home audience.Furthermore, we need to explicitly differentiate the uncertainty regardingnatural outcomes from the ‘strategic uncertainty’, which is brought upon usdue to the fact that we are playing a strategic game with other countries. Theclimate change problem that Australia is confronting today is part of a gamebecause every country’s actions impact everybody else. The strategic nature ofthis problem might have been overlooked so far. The best strategy we can playis a function of other players’ strategies, which themselves depend on theiropponents’ strategies, and so on.4  Stern (2006) is a report about climate change officially commissioned by the British government in2005.86Agenda, Volume 15, Number 2, 2008The repeated nature of the players’ interaction is very important. Theliterature points out that agents playing repeated games may obtain, on average,much better outcomes than they would in a static environment, if they aresufficiently patient. This kind of result is usually known as a ‘folk theorem’. Ina long, repeated strategic interaction it is possible to create incentives forcooperation by punishing, or threatening to punish, deviators. To formulate anoptimal strategy one needs to design a contingent plan of action for every historyof action profiles that all nations have played. In other words, our plan must bequite flexible and prescribe our actions under many different circumstances.Unfortunately, however, the theories of dynamic games and repeated gameswith incomplete information are still unfinished. There are many open questionsand more research is needed. In particular, the theory of dynamic stochasticgames is not well developed. Studying climate change with this tool may be thebest way to develop critical insights and to design sensible policies, but fewresearch papers use this analytical framework.5Nevertheless, game theory is the most reasonable framework to date fordealing with the strategic and repeated interaction of many governments whenthey all face uncertainty. For instance, any Nash equilibrium of a repeated gamealways explicitly describes what are the possible punishments players may faceand the incentives that other players have to carry out each prescribedpunishment. In other words, all nations have the incentive to keep to theequilibrium path, and, if a country is called upon to punish a deviator, it willin fact have sufficient long-run incentive to carry on the punishment even ifthis means short-run losses. In sum, the concepts of Nash equilibrium andsub-game perfect equilibrium are based on credible threats.What level of international cooperation is likely to occur in practice? DoesAustralia need to have a direct benefit to reduce its emissions, given that we arenot a major polluter? Is there a ‘first move’ advantage in this game or is it justsilly to cut emissions now before others commit themselves to a long-runagreement?Making a first move in cutting emissions is costly in the short run, but itcould place us in a more favourable position in the future. There are at leastthree different reasons for this. First, it may smooth consumption, allowinginternal agents to adjust more gradually to cleaner technologies. Second, itprovides incentives for Australian scientists and technicians to take the lead inthis research area. Third, it establishes our international reputation as a leaderin the field, both in the policy area and in scientific and technological5 The lack of research on climate change with up-to-date decision theoretical and game theoretical toolsis not only a problem for Australia. To the best of our knowledge, there is no climate change model thatsimultaneously incorporates the recent findings of research in ambiguity aversion and stochastic dy-namic game theory. We thank an anonymous referee for bringing this point to our attention.87Climate Change Policy: A Theorist’s Plea to Take Heed of Game Theory and Ambiguity Aversiondevelopment. There is an extensive literature on the value of reputation and onreputation-building.6The Howard government was criticised for not signing the Kyoto Protocol.Has Australia lost the initiative and reputation when it comes to climate change?If so, how bad is this for future agreements? Solid scientific answers are likelyto require the use of sophisticated game theory. In particular, the theory ofrepeated games with incomplete information seems to be necessary. In any event,it is wise for Australia to actively participate in the international debate becauseclimate change may impact our country even if our own direct actions turn outto have little or insignificant direct impact. If we understand the situation well,we may help in the design of international agreements, efficient policies andnew technologies that may change everybody’s future.Sceptics such as Alex Robson claim that Australia is a minor polluter andthat huge sacrifices may not have a significant impact on the global situation.7Even if this is true, Australia may be punished by other countries if we do notadhere to major international agreements. It does not seem wise to count on freeriding on other countries’ emissions cuts. A dynamic decision theoretic approachmust be established. Being flexible with any possible numerical target does notmean that Australia has a weak attitude towards climate change. The importantpoint is that we must be capable of using the most recent and accurate scientificinformation and technologies available. Such information and new technologieswill come from future developments in both natural and social sciences.Game theory has been criticised for not working with quantitative questions.In fact, it is a relatively common mistake to consider quantitative results as beingof more use or of having more applicability then qualitative results.8 We arguethat more important than knowing the exact numbers of the reduction inemissions and their costs, the very nature of desirable equilibria must beestablished first. How often are emissions going to be measured and what, ifany, structure of punishments will be capable of enforcing optimal equilibrium?How complex will the strategies need to be? Is it a good idea to have a singleround of ‘hard’ punishments for deviators or are longer ‘soft’ punishments more6  For some of the most recent references, see Cripps et al. (2004), Mailath and Samuelson (2006) and Elyet al. (2008).7  See Robson (2007a).8  It is not hard to see scientists who use alternative approaches to study Climate Change criticising gametheory for different reasons. Typically, they make unfair claims and work with a variety of alternativessuch as optimal control theory, purely empirical studies or general equilibrium models. We regard mostof these criticisms as a natural outcome in an environment where scientists are highly specialised andthere is intense competition for research funds and academic prestige. These alternative techniquesusually miss important and complex elements of the question because they do not focus on the strategicnature of the problem. The fact that several pure and applied game theorists have recently won NobelPrizes is a good indication of the power and potential of this field.88Agenda, Volume 15, Number 2, 2008effective? Before addressing these qualitative issues, very specific quantitativequestions are unlikely to get realistic answers.How will we deal with disputes in the measurements? Again, game theorymay save the day. Imperfect monitoring is also explicitly studied by the theoryof repeated games.9 The good news here is that the literature has some resultsindicating that much of the structure of folk theorems is saved, with sometechnical adjustments, when one introduces imperfect monitoring.Certainly, it is costly to invest in research. Game theory is an abstract, hard,highly mathematised discipline. But it may turn out to be much more costly forAustralians not to invest in this field. Without explicitly incorporating thesetwo elements into the discussion — namely, ambiguity aversion and the strategicand repeated nature of the nations’ interaction — much of the argument will becircular, or based on individual preferences or attitude towards risk anduncertainty. The debate will continue to be rich in factual knowledge, but pooron strategic reasoning. The sooner the discussion in Australia incorporatesdecision theoretic and game theoretic concepts, the correct tools for qualitativestudies, the sooner social scientists will enter on the right track to attack problemsrelated to climate change.ReferencesCripps, M., Mailath, G. and Samuelson, L. 2004, ‘Imperfect Monitoring and Im-permanent Reputations’, Econometrica 72: 407–32.Ellsberg, D. 1961, ‘Risk, ambiguity, and the Savage axioms’, Quarterly Journalof Economics 75: 643–69.Ely, J., Fudenberg, D. and Levine D. 2008, ‘When is reputation bad?’, Gamesand Economic Behavior, forthcoming.Ghirardato, P., Maccheroni, F. and Marinacci, M. 2004, ‘Differentiating ambiguityand ambiguity attitude’, Journal of Economic Theory 118: 133–73.Knight, F. H. 1921, Risks, Uncertainty, and Profit, Boston: Houghton-Mifflin.Kreps, David M. 1988, Notes on the Theory of Choice, Underground Classics inEconomics, Westview Press.Mailath, G. and Samuelson, L. 2006, Repeated Games and Reputations: Long-runRelationships, Oxford University Press.Marinacci, M. 2000, ‘Ambiguous Games’, Games and Economic Behavior 31:191–219.McKibbin, W. 2007a, ‘The Prime Ministerial Task Group on Emissions Trading:An Assessment’, Agenda 14(3): 13–7.9  See Mailath and Samuelson (2006).89Climate Change Policy: A Theorist’s Plea to Take Heed of Game Theory and Ambiguity AversionMcKibbin, W. 2007b, ‘Reply to Quiggin and Robson’, Ibid.: 29–30.Potamites, E. and Zhang, B. 2007, ‘Heterogeneous Ambiguity Aversion: a fieldexperiment among small-scale stock investors in China,’ working paper,at: http://beizhangbei.googlepages.com/BeiZhangPaper2.pdfQuiggin, J. 2007a, ‘The Prime Ministerial Task Group on Emissions Trading:Advocacy and Analysis’. Agenda 14(3): 5–12.Quiggin, J. 2007b, ‘Reply to McKibbin and Robson’, Ibid.: 27–8.Robson, A. 2007a, ‘The Prime Ministerial Task Group on Emissions Trading: AnAssessment’ Agenda 14(3): 13–7.Robson, A. 2007b, ‘Reply to McKibbin and Quiggin’, Ibid.: 31–2.Stern, N. 2006, ‘Stern Review on the economics of climate change’ at: ht-tp://www.hm-treasury.gov.uk/independent_reviews/stern_review_eco-nomics_climate_change/stern_review_report.cfmWeitzman, Martin L. 2007, ‘A Review of the Stern Review on the Economics ofClimate Change’, Journal of Economic Literature 45(3): 703–24.Zhang, B. 2007, ‘Measuring Ambiguity Attitudes and Beliefs: an ExperimentalStudy’, working paper: http://beizhangbei.googlepages.com/BeiZhang-Paper1.pdf90Agenda, Volume 15, Number 2, 2008

Climate change policy: a theorist's plea to take heed of game theory and ambiguity aversion

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