Optimal Expectations and the Welfare Cost of Climate Variability

Abstract

We show 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 e↵ect on life satisfaction to a two standard deviation (1-2%) decrease in consumption. This e↵ect is one of the largest determinants of life satisfaction in rural Ethiopia. (JEL: C25, D60, I31.) 1First draft: June 2012. Alem: Department of Economics, University of Gothenburg, Sweden, yonas.alem@economics.gu.se. Colmer: The Grantham Research Institute and Department of Geography and Environment, London School of Economics, UK. E-mail: j.m.colmer@lse.ac.uk. We are grateful to Allen Blackman, Je↵ery Bookwalter, Gharad Bryan, Douglas Dalenberg, Paul Dolan, John Feddersen, Greer Gosnell, Cameron Hepburn, Derek Kellenberg, Peter Martinsson, Kyle Meng, Rob Metcalfe, Eric Neumayer, Jonathan Parker, Hendrik Wol↵ and seminar participants at the EfD 6th Annual Meeting, EAERE, the University of Oxford, London School of Economics, University of Montana, and Resources for the Future for helpful thoughts, comments and discussions. The first author would like to thank the Swedish International Development Agency (Sida) through the Environment for Development Initiative (EfD) at the University of Gothenburg, and the Swedish Research Council Formas through the Human Cooperation to Manage Natural Resources (COMMONS) programme for financial support. Part of this research was done while Alem was a Visiting Scholar at the Department of Agricultural and Resource Economics, University of California Berkeley. The second author would like to thank the ESRC Centre for Climate Change Economics and Policy and the Grantham Foundation for financial support. The data used in this article were collected by the University of Addis Ababa, the International Food Policy Research Institute (IFPRI), and the Centre for the Study of African Economies (CSAE). Funding for the ERHS survey was provided by the Economic and Social Research Council (ESRC), the Swedish International Development Agency (SIDA) and the United States Agency for International Development (USAID). All errors and omissions are our own.