Ruhr Economic Papers

Ruhr Economic Papers #780

Consumption Smoothing and the Welfare Cost of Uncertainty

by Yonas Alem and Jonathan Colmer

RWI Research Network, 12/2018, 98 S./p., 12 Euro, ISBN 978-3-86788-908-7 DOI: 10.4419/86788908

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Abstract

Separating the effects of uncertainty from realised events, and identifying the welfare
effects of uncertainty, present a number of empirical challenges. Combining individuallevel
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.

JEL-Classification: I131, O13, Q12, Q56

Keywords: Income uncertainty; consumption smoothing; subjective well-being; rainfall variability

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