London School of Economics EOPP: Economic Organisation and Public Policy Programme LSE
EOPP: Economic Organisation and Public Policy Programme

Abstract for:

Consumption Smoothing and the Welfare Cost of Uncertainty

Yonas Alem, Jonathan Colmer, August 2015
Paper No' EOPP 059: | Full paper (pdf)
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Keywords: Uncertainty, Consumption Smoothing, Subjective Well-Being

JEL Classification: D8; O12; I3

Is hard copy/paper copy available? YES - Paper Copy Still In Print.
This Paper is published under the following series: Economic Organisation and Public Policy Discussion Papers
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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.