Joanna Nestorowicz for Prof. M. Nonneman Contemporary Issues in Economic Policy Task#2: 11.03.2008

Increasing Income Inequality External Habits, and Self-Reported Happiness By Karen E. Dynan and Enrichetta Ravina published in American Economic Review (2007), Vol. 97, Issue 2, pp 226-231. The United States have been reporting income convergence during the past 25 years. The paper is an attempt to examine how this macroeconomic feature impacts the overall happiness of the American society. Basic economic theory behind the study states that an individual’s utility depends on consumption. This notion has been given reconsideration though. An individual’s utility is said not to depend only on his/her own consumption level, but also on the comparison of how that level relates to consumption levels of others. Reference is made to studies which are said to confirm the legitimacy of such an approach. Used measures of happiness and relative income are derived from the General Social Survey and the Current Population Survey Anual Earnings Files respectively. The measure of relative income is constructed from data on occupation, state of residence and year; the authors report gradual increase in its standard deviation over time. Further research is based on regression analysis. The dependant variable is a measure of happiness. Independent variables are: change in individual’s income, individual’s relative income and a set of control measures (age, gender, race, education, martial status, family size). The final estimation is based on 60,000 person-year observations ranging from 1979 to 2004. It is highlighted though, that the measure used to explain the levels of happiness is income, and not consumption. Although often used interchangeably, the two concepts differ due to possibility of consumption-smoothing behaviour with simultaneous lagging-behind in terms of income. When it came to interpreting the results it also appeared that all the variables still have low explanatory power. The main finding of the work is that, when all of the specified variables are controlled for, an increase in an individual’s income is significantly correlated with his/her level of self-reported happiness. Further research is conducted by adding a dummy variable indicating above-average/below-average income of the whole group. The interpretation of the results suggests that in groups below average, people’s happiness is weakly affected by income divergence. The situation is opposite in relatively high income groups. It has been additionally noted though, that this effect holds for people, who are not extremely rich (falling into the highest percentile of group income distribution). Consequent tests have been also performed to check for robustness of the results. Considering median instead of mean income gave similar results. Refinement in occupation categories, controlling for unemployment and housing prices yielded no significant changes as well. Apart from the findings mentioned above higher levels od happiness are reported by women, married couples, older people, members of smaller families and better educated persons. Finally the paper proposes two other correlational studies which might shed new light on the interdependence of consumption and happiness. It is suggested that due to consumption externalities households may choose to consume more by increasing labor supply or taking loans. Another hypothesis mentions skewing a household’s consumption basket towards more visible goods in order to be better perceived in the society.