Consumption smoothing and the welfare cost of uncertainty

Yonas Alem and Jonathan Colmer

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: When agents are unable to smooth consumption and have distorted beliefs about the likelihood of future income realisations, uncertainty about future states of the world has a direct effect on individual welfare. However, separating the effects of uncertainty from realised events and identifying the welfare effects of uncertainty both present a number of empirical challenges. Combining individual-level panel data from rural and urban Ethiopia with high-resolution meteorological data, we estimate the empirical relevance of uncertainty on objective consumption and subjective well-being. While negative income shocks affect both objective consumption measures and subjective well-being, greater income uncertainty only has an affect on subjective well-being. A one standard deviation change in income uncertainty is equivalent to a one standard deviation change in realised consumption. These results indicate that the welfare gains from further consumption smoothing are substantially greater than estimates based solely on consumption fluctuations.

Keywords: Uncertainty; consumption smoothing; subjective well-being (search for similar items in EconPapers)
JEL-codes: D8 I3 O12 (search for similar items in EconPapers)
Pages: 8 pages
Date: 2015-08
New Economics Papers: this item is included in nep-hap and nep-pbe
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