Inertia Risk: Improving Economic Models of Catastrophes

We model endogenous catastrophic risk in a new way that 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.