LONG‐RUN EQUILIBRIA IN AN ECONOMY WITH A GREENHOUSE EFFECT

Abstract

This paper examines perfect foresight inter‐generational macroeconomic tradeoffs associated with climate change. Consumption of perfectly competitive agents is associated with exacerbation of the climate change problem. Saving and investment reduce exposure to a negative production externality caused by the greenhouse effect, through a non‐probabilistic catastrophic threshold. In this overlapping generations economy, saving and investment provide benefits to future generations that current individuals are unable to capture. Two kinds of equilibria are shown to exist. The gas stock may remain at a constant or declining level so the threshold does not matter in steady‐state equilibrium even with population growth, where consumption, investment and production are all constant in per capita terms. When the threshold does matter because the gas stock is growing in steady state, agents flirt with catastrophe, make strategic economic decisions based on what other agents are doing, and optimize by walking a knife‐edge of disaster at the threshold. Like the private provision of a public good, price‐taking agents internalize the public bad. This is the focal point symmetric Nash equilibrium, but the potential for a coordination failure is also shown to exist where agents with perfect foresight would find it optimal not to end the economy, but are unable to avoid doing so.