Consumption Smoothing and the Welfare Cost of Uncertainty

Yonas Alem and Jonathan Colmer

CEP Discussion Papers from Centre for Economic Performance, LSE

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.

Keywords: Uncertainty; consumption smoothing; subjective well-being; rainfall variability (search for similar items in EconPapers)
JEL-codes: O13 Q12 Q56 (search for similar items in EconPapers)
Date: 2015-08
New Economics Papers: this item is included in nep-hap
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