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Consumption Smoothing and the Welfare Cost of Uncertainty

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  • Yonas Alem
  • Jonathan Colmer

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 effect 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.

Suggested Citation

  • Yonas Alem & Jonathan Colmer, 2015. "Consumption Smoothing and the Welfare Cost of Uncertainty," STICERD - Economic Organisation and Public Policy Discussion Papers Series 059, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE.
  • Handle: RePEc:cep:stieop:059
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    File URL: http://sticerd.lse.ac.uk/dps/eopp/eopp59.pdf
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    References listed on IDEAS

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    More about this item

    Keywords

    Uncertainty; Consumption Smoothing; Subjective Well-Being;

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • O12 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Microeconomic Analyses of Economic Development
    • I3 - Health, Education, and Welfare - - Welfare, Well-Being, and Poverty

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