Income differences between people

People with higher income have more opportunities to achieve whatsoever they desire: they can buy more material goods and services. Moreover, they have a higher status in society. Higher income therefore yields higher utility, and conversely the poor are unhappy. This relationship between income and happiness at a given point in time and in a particular location (country) has been the subject of a large empirical literature. As a robust and general result, it has been found that richer people, on average, report higher subjective well-being. The relationship between income and happiness, both in simple regressions and when a large number of other factors are controlled for in multiple regressions, proves to be positive and sizeable (provided, of course, that the two are correctly measured). In this sense, income does buy happiness.

However, additional income does not, of course, raise happiness ad infinitum and cannot be depended on to raise happiness (Diener et al., 1993; Ng, 2001a). Increases in happiness tail off as absolute income rises. Moreover, the low proportion of differences in happiness among people that can be explained by differences in income indicates that other factors are also important in explaining why some people are happier than others.

As has already been pointed out for the case of income level in society, correlations do not establish causation. It may well be that it is not higher individual income that makes people happier, but rather that happier people earn higher income, e.g. because they like to work harder, and are more enterprising. In order to test the direction of causation, windfalls determining income have been analysed. British lottery winners and following year. An unexpected transfer of £50,000 is estimated to raise subjective well-being by between 0.1 and 0.3 standard deviations. This suggests that the causation runs indeed from income to happiness.

There may be many different reasons why higher income does not simply translate into higher happiness. One of the most important ones, without doubt, is that people compare themselves to other people. It is not the absolute level of income that matters most, but rather one’s position relative to other people. Many economists in the past have noted that individuals compare themselves to others with respect to income, consumption, status or utility. Thorstein Veblen (1899) coined the notion of ‘conspicuous consumption’, serving to impress other people. The ‘relative income hypothesis’ was formulated and econometrically tested by James Duesenberry (1949), who posited an asymmetric structure of externalities. People look upwards when making comparisons. Aspirations thus tend to be above the level already reached. Wealthier people impose a negative external effect on poorer people, but not vice versa. Fred Hirsch (1976), in his book Social Limits to Growth, emphasised the role of relative social status by calling attention to ‘positional goods’ which, by definition, cannot be augmented, because they rely solely on not being available to others. This theme was taken up by Robert Frank (1985, 1999), who argued that the production of positional goods in the form of luxuries, such as exceedingly expensive watches or yachts, is a waste of productive resources, as overall happiness is thereby decreased rather than increased.

There is little doubt that people compare themselves to other people and do not use absolute judgements. But it is crucial to know with which other people such a comparison is being made. In a study of 5,000 British workers, the reference group is formed to comprise people with the same labour market characteristics. It is concluded that the higher the income of the reference group, the less satisfied people are with their job (Clark and Oswald, 1996).

The distribution of income also affects happiness. It does so over and above the individual income level. There is a negative effect of inequality on happiness in Europe, but no such effect is measured in the US. This is consistent with the observation that Europeans tend to have inequality aversion, while Americans do not. Upward social mobility is perceived to be larger in the US than in Europe, therefore being low on the scale of income distribution is not necessarily seen as affecting future income (Alesina et al., 2001).

Most of the research on the relationship between individual income and happiness has been undertaken for advanced industrial countries. But it has been shown (Graham and Pettinato, 2001) that the results for individual income essentially carry over to both developing countries and tocountries in transition.

The effect of inflation on happiness

In combined time series-cross section studies, it has been shown that a higher inflation rate substantially reduces reported happiness. For 12 European countries over the period 1975–91, it has been calculated that an increase in the inflation rate by five percentage points—say from the mean rate of 8% to 13% per year—reduces average happiness by 0.05 units of satisfaction, i.e. from an average level in the sample of 3.02 to 2.97 (Di Tella et al., 2001). This is a substantial amount. It means that 5% of the population are shifted downwards from one life satisfaction category to the next lower one, e.g. from being ‘very satisfied’ to ‘fairly satisfied’.

Trade-off between unemployment and inflation

The results on the effect of unemployment and inflation on happiness can now be combined. The question is: by how much, on average, must a country reduce its inflation in order to tolerate a rise of one percentage point in unemployment? It has been calculated for the twelve European countries referred to above (Di Tella et al., 2001) that a one percentage point increase in the unemployment rate is compensated for by a 1.7 percentage point decrease in inflation. Thus, if unemployment rises by five percentage points (say from 3% to 8%), the inflation rate must decrease by 8.5 percentage points (say from 10% to 1.5% per year) to keep the population equally satisfied. This result significantly deviates from the ‘Misery Index’ which, for lack of information, has simply been defined as the sum of the percentage unemployment rate and the percentage annual inflation rate. This index distorts the picture by attributing too little weight to the effect of unemployment, relative to inflation, on self-reported happiness.

Date: 2014-12-21; view: 891