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Optimal Expectations and the Welfare Cost of Climate Variability

  • Alem, Yonas


    (Department of Economics, School of Business, Economics and Law, Göteborg University and UC Berkeley)

  • Colmer, Jonathan


    (the Grantham Research Institute and Dept of Geography and Environment, London School of Economics, UK)

Uncertainty about the future is an important determinant of well-being,especially in developing countries where financial markets and other market failures result in ineffective insurance mechanisms. However, separating the effects of future uncertainty from realised events, and then measuring its impact on utility presents a number of empirical challenges. This paper addresses these issues and shows that increased climate variability (a proxy for future income uncertainty) reduces farmers’ subjective well-being, consistent with the theory of optimal expectations (Brunnermeier & Parker, 2005), using panel data from rural Ethiopia and a new data set containing daily atmospheric parameters. The magnitude of our result indicates that a one standard deviation (7%) increase in climate variability has an equivalent effect on life satisfaction to a two standard deviation (1-2%) decrease in consumption. This effect is one of the largest determinants of life satisfaction in rural Ethiopia.

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Paper provided by University of Gothenburg, Department of Economics in its series Working Papers in Economics with number 578.

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Length: 54 pages
Date of creation: 10 Dec 2013
Date of revision:
Handle: RePEc:hhs:gunwpe:0578
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Department of Economics, School of Business, Economics and Law, University of Gothenburg, Box 640, SE 405 30 GÖTEBORG, Sweden

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