Adjustment Costs and Climate Change Adaptation
A 1970s Paper by Chetty and Heckman Anticipates a Modern Identification Problem
We economists think of ourselves as “detectives”. We observe some clues about our world. We assume that people’s choices are thought out and purposeful and we infer insights about people based on what they choose to do. I wrote a 99 cent Amazon E-book that explores this theme through many examples.
Let’s discuss a specific example that will interest people who are concerned about our ability to adapt to climate change.
My mother in-law is in her 80s. She lives in a home in Berkeley, California that was built in the 1920s and it does not have air conditioning. America was poorer back in the 1920s and no homes back then had central air conditioning. My wife’s parents bought this home back in 1964 and never installed air conditioning. In the recent past, Berkeley rarely experienced high temperature days. Due to climate change, Berkeley is getting hotter and some new homes now have central air conditioning. Many, many Los Angeles homes have central air conditioning. A simple model of choice under uncertainty explains why. In areas where it is expected to be hot, people are more likely to make lumpy investments in central air conditioning to help them cope with an anticipated threat.
My mother in-law knows that Berkeley is getting hotter but she doesn’t want to be hassled with the short term disruption of having a team install the air conditioning. She also anticipates that the next owner of her house is likely to knock it down and build a new house.
So, in the short run — my mother in-law faces adaptation risk. She could be exposed to very hot days because she doesn’t want to bear the adjustment costs of matching her old home to its new climate.
Given my past work on climate change adaptation, it is clear to me that she has an ever growing market strategy set for coping with these hot days. On extremely hot days, she could check in to an air conditioned hotel or go to an air conditioned Mall. The key is have a weather alert that extremely hot weather will take place over the next 10 days. This is sufficient to nudge individuals to engage in precautionary actions and the researcher who studies “health and heat exposure” then observes that people like my mother in-law are in good health even on very hot days. The anticipation that extreme weather could injure her nudges her to take precautionary actions so that the climate researcher subsequently observes a “flat climate damage function” for middle class people.
A flat climate damage function means that on very hot days that few people are made sick by the heat. Read this 2017 paper on long run adaptation progress.
The interesting feature of my mother in-law’s old house is that durable capital slows down our economy’s adaptation to new threats. In growing cities such as a Las Vegas, the capital stock is newer and better matched to the new weather conditions. In old cities such as Berkeley with little new housing being built, the average house is old and isn’t correctly matched with the new weather conditions. I explore this point in this 2017 paper.
With this preamble, let’s now turn to the Chetty and Heckman 2023 paper that was started in the early 1970s.
Here is the last sentence from the paper’s abstract:
“Adjustment costs create the appearance of static inefficiency in the presence of dynamic efficiency.”
Many climate economists who question our economy’s ability to adapt to climate change implicitly embrace a strong behavioral economics perspective of people who cannot update their beliefs about their risk exposure and use markets to protect themselves. I discuss this point at length in my 2015 paper.
The Heckman and Chetty paper documents an identification problem. At any point in time, there can be economic decision makers who look “slow and sluggish” in responding to a new challenge or opportunity. The behavioral economist is quick to label them “slugs” while a neo-classical economist’s explanation for the static fact is that the economic decision maker, who faces adjustment costs, has chosen not to exercise her option yet. My mother in-law would install air conditioning if she expected that Berkeley heat would rise to 120F each day in summer.
Could she not get a smaller portable unit that would make a big difference in whatever room she spends most time in?