Hysteresis and the Welfare Effect of Corrective Policies: Theory and Evidence from an Energy-Saving Program

This paper studies how one may overestimate the social cost of a long-run corrective policy by neglecting the possibility of hysteresis, i.e., that the policy in earlier periods may have a persistent impact in the long run. In a price-theoretic framework, we show that one statistic is key to evaluating this bias: the long-term impact of a similar but temporary policy that was known to be temporary. We then provide evidence of the importance of hysteresis, and estimate such a statistic, for a policy-relevant behavior: residential electricity use in a developing country context. We study the 10-year impact of a 9-month long policy in Brazil, which aimed at large temporary reductions in residential electricity use. Through a difference-in-difference strategy, we exploit the fact that customers of some distribution utilities were not subject to the policy. Using utility-level administrative data, we find that the temporary policy led to a long-run and stable reduction in average electricity use of 11%, or about half of the short-run impact. Using individual monthly billing data for one distribution utility, we find that 69% of customers were still consuming less electricity four years after the policy ended. Household-level microdata suggest that the main mechanism of hysteresis is a persistent change in consumption habits. Incorporating our estimates into this framework illustrates that, by neglecting the possibility of hysteresis, one could dramatically overestimate the social cost of long-run corrective policies.