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 (±) 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. © 2005 Elsevier Inc. All rights reserved.