Optimal Expectations and the Welfare Cost of Climate Variability: A Subjective Well-Being Approach

Using panel data from rural Ethiopia, combined with a new data set containing daily atmospheric parameters, we show that increased climate variability (a proxy for future income uncertainty) reduces farmers’ subjective well-being, in line with the theory of optimal expectations (Brunnermeier and Parker, 2005). The magnitude of our result indicates that a one standard deviation 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.) 1Alem: Department of Economics, University of Gothenburg, Sweden, [email protected]. Colmer: The Grantham Research Institute and Department of Geography and Environment, London School of Economics, UK. E-mail: [email protected]. We are grateful to Rob Metcalfe, Gharad Bryan, Paul Dolan, John Feddersen, Eric Neumayer, Allan Blackman, Peter Martinsson, Derek Kellenberg, Douglas Delenberg, Je↵ery Bookwalter, Greer Gosnell 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 and comments. 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. All errors and omissions are our own.