Adjustment costs from environmental change

Abstract

The paper is concerned with the case whereby the distribution of a firm's productivity shocks changes without the knowledge of the firm. Over time the firm learns about the nature and extent of the change in the distribution of the shock and adjusts, incurring adjustment costs in the process. The long-run loss in profits $(\pm )$ due to the shift in the distribution we term the equilibrium response. The transitory loss in profits, incurred while the firm is learning about the distribution shift, is termed the adjustment cost. The theory is then applied to the problem of measuring adjustment costs in the face of imperfectly observed climate change in agriculture. The empirical part of the paper involves estimating a restricted profit function for agricultural land in a five-state region of the Midwest US as a function of prices, land characteristics, actual weather realizations and expected weather. We then simulate the effect of an unobserved climate shock, where learning about the climate shock is by observing the weather and updating prior knowledge using Bayes Rule. We find adjustment costs to climate change are 1.4% of annual land rents.

Introduction

Climate change is clearly one of today's leading global environmental problems, brought on by an increase in atmospheric levels of carbon dioxide and other greenhouse gases. Climate change may manifest itself in many ways, including changes in average temperature and precipitation, variability of weather (such as more frequent hurricanes), and sea levels.¹

One of the most important issues in the climate change debate is the quantification and monetization of the market and non-market impacts (damages) from a change in the climate. Most quantitative estimates of damages are modest, which tends to contradict the intuition of many that a significant change in the climate must have very serious consequences.²

Early damage studies measured the short-run response from climate change: if temperatures rise rapidly, what are the losses to a sector (e.g., agriculture), assuming the sector has no time (or inclination) to change practices and adapt?³ Assuming away adaptive actions is known as the “dumb farmer” assumption.⁴ This was the norm for estimates of damage in the late 1980s and early 1990s.

Recognizing the inappropriateness of assuming away agent adaptive response to climate change, other authors have assumed agents have time to react and adapt to climate change. This implicitly quantifies the long-run impact from climate change, for instance after farmers adapt to the changed climate and after coastal areas adapt to newly defined shorelines. In fact, in the long-run, climate change could have a positive effect, at least on certain sectors and regions. Adaptation is now recognized as an important factor in moderating potential impacts of climate change, a factor which must be incorporated into estimates of damage.⁵

A third issue, which has received very little attention in the literature (and which is the subject of this paper), concerns the path from short-run to long-run—the adjustment process with associated adjustment costs. When a shock occurs, agents cannot instantly adapt. More precisely, adjustment costs are the extra costs incurred relative to the (counterfactual) case of instantly adapting to changed circumstances.⁶

The nature of adjustment costs can most easily be understood in the context of a firm subject to a one time price shock for one of its inputs. The literature on the theory of the firm subject to price shocks (beginning with Lucas [21] and nicely summarized in [4]), distinguishes between short-run response, long-run response and the additional costs of adjusting from the short- to the long-run. After the price shock, if the firm makes no attempts to adjust inputs, it will suffer the maximal profit loss. However, the firm can adapt, changing production technique, moderating the loss in profit. But the firm may not be able to adjust its inputs quickly—capital for instance takes time to replace. Additional losses will occur, compared to the case of complete flexibility and ability to instantly respond to the shock. These extra costs are termed “adjustment costs.”

An analogous process occurs with climate change, though instead of a price shock we have a technology shock—the change in climate. When the climate changes, maximal profit loss occurs if the firm makes no changes in its production techniques; i.e., remains a “dumb farmer.” This loss can be moderated by adaptation, reducing the profit loss. Agents are slowed in their ability to instantly adapt to the changed climate for two reasons: input (e.g., capital) fixity and incomplete knowledge of the climate change. In this paper, we focus on the later source of adjustment costs.

There are two purposes of this paper. One is to provide a theoretical structure for viewing adjustment in the context of environmental change, specifically climate change. The second is to apply this theoretical structure and measure adjustment costs; in particular, we consider agriculture and examine the costs of adjustment in US agriculture in the Midwest, a relatively homogenous region agriculturally.

In this paper, the inability to instantly adjust to a changed climate arises because the economic agent (think of a farmer) does not perfectly observe the climate change: the farmer only slowly realizes that the climate has changed. The farmer forms her subjective assessment of what weather might be for the coming year based on currently available information (IPCC predictions and historical weather). Given this structure, we simulate how a farmer would react to an unobserved change in the climate (i.e., the distribution of weather). The farmer would initially think she is seeing unusual weather, only slowly updating her estimate of the true climate. Eventually she learns the true nature of the change in the climate; in the meantime, her production decisions are suboptimal (relative to perfect information) and thus her profits suffer, generating adjustment costs.

To implement this concept of adjustment costs, we first econometrically estimate how US farm profit is influenced by a variety of factors, including realized weather and expectations about weather. Expectations are assumed to be derived from observing past weather. We then simulate how farmers would respond to a change in climate (mean temperature and precipitation). We consider two cases, one where the farmer is fully informed of the change in the climate and another where the farmer only realizes the climate has changed by observing unusual weather and slowly updating her prior on the climate. The difference in profits for these two cases is the adjustment cost.

We argue that adjustment costs are likely to be quantitatively important for many cases of environmental change. Environmental change results in many winners and losers, which tend to cancel each other out. But adjustment costs are a cost to everyone, regardless of whether or not eventually environmental change is a benefit or a cost.

Indeed, we show that incomplete knowledge of the climate can indeed lead to a loss in profits. We examine agriculture in the Midwest using data from the 1976–1997 period, and then simulate what might happen over a century from gradual unobserved climate change.⁷ Although we find that this change in climate eventually increases annual expected profits by 3.7%, the net present value of adjustment costs is 1.4% of annual land rents. In absolute net present value terms, in our sample climate change results in a long-run gain of $0.54 billion but adjustment costs of $0.24 billion, for a net gain of $0.30 billion.