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Consumption Smoothing and the Welfare Cost of Uncertainty

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  • Yonas Alem
  • Jonathan Colmer

Abstract

Separating the effects of uncertainty from realised events, and identifying the welfare effects of uncertainty, present a number of empirical challenges. Combining individual-level panel data from rural Ethiopia with high-resolution meteorological data, we introduce a new proxy for income uncertainty - mean-preserving rainfall variability - and estimate that an increase in income uncertainty is associated with reductions in objective consumption and subjective well-being (SWB). Furthermore, 86% of the effect on SWB is attributed to the direct effects of uncertainty, consistent with a model of optimal expectations (Brunnermeier and Parker, 2005). In addition, we find that farmers in more uncertain environments are more resilient to realised rainfall shocks, consistent with a trade-off between optimism about the future and risk-management investments today. These findings suggest that the gains from further consumption smoothing are likely greater than estimates based solely on realised consumption fluctuations.

Suggested Citation

  • Yonas Alem & Jonathan Colmer, 2015. "Consumption Smoothing and the Welfare Cost of Uncertainty," CEP Discussion Papers dp1369, Centre for Economic Performance, LSE.
    • Handle: RePEc:cep:cepdps:dp1369
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    References listed on IDEAS

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    Blog mentions

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    1. Ethiopian Rural Household Surveys
      by Masa in Devecondata on 2016-05-16 17:14:00

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    More about this item

    Keywords

    Uncertainty; consumption smoothing; subjective well-being; rainfall variability;
    All these keywords.

    JEL classification:

    • O13 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Agriculture; Natural Resources; Environment; Other Primary Products
    • Q12 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Agriculture - - - Micro Analysis of Farm Firms, Farm Households, and Farm Input Markets
    • Q56 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Environment and Development; Environment and Trade; Sustainability; Environmental Accounts and Accounting; Environmental Equity; Population Growth

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