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Development Discussion Paper
Consumption Smoothing and the Welfare Cost of Uncertainty
Yonas Alem and Jonathan Colmer
August 2015
Paper No' EOPP 059:
Full Paper (pdf)

JEL Classification: D8; O12; I3

Tags: uncertainty; consumption smoothing; subjective well-being

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.