Social Reference and Adaptation Effects on Happiness: A Dynamic Approach

Gülçin Mente?o?lu & Maarten Vendrik[1]

Abstract for the Conference:

Happiness and Relational Goods: Well-being and

Interpersonal Relations in the Economic Sphere

Venice, June 11-13, 2009

A central finding in happiness research is that individual life satisfaction depends on the level of  income relative to a social reference group rather than the absolute level of income (McBride, 2001; Ferrer-i-Carbonell, 2005; Luttmer, 2005; Vendrik and Woltjer, 2007). Additionally, life satisfaction depends negatively on one’s own income in the past (hedonic adaptation; Di Tella et al., 2005; Weinzierl, 2006). These phenomena are important since they impose positional externalities and myopic habit formation effects on consumption and labour supply decisions. From a social-welfare point of view, these effects may lead to inefficiently high consumption levels and hence inefficiently high working hours to finance such consumption expenses (Layard, 2005a, 2005b).

However, most empirical studies implicitly assume that there are no social-reference and adaptation effects with respect to working hours or leisure. Moreover, as far as adaptation to income is modelled, this is not controlled for dynamics in other variables (e.g., D’Ambrosio and Frick, 2007). Just like hedonic adaptation with respect to income implies a difference between its short and long-run effects on happiness, there may also be different short and long run effects on happiness of changes in social reference income, working hours, social reference working hours, and all kinds of objective living conditions like marriage, divorce, birth of first child, layoffs and unemployment (Clark et al., 2006b). Such dynamics in variables other than own income may be correlated to the income dynamics and should therefore be controlled for. Our paper improves on this by simultaneously estimating short and long-run effects of income, social reference income, working hours and social reference working hours while controlling for the short and long-run dynamics of life satisfaction with respect to a large set of control variables. The individual-specific reference groups are defined as peer groups of similar age and education and of the same gender.

Another complication that we take care of is possible endogeneity and spurious correlations of income to life satisfaction. People may earn more if they are happier and individual-specific time-varying factors may lead to both greater satisfaction and higher income (Clark et al., 2006a). Results of Luttmer (2005) and Luechinger (2007) using an instrumental variable for income suggest that this can have dramatic consequences for estimates of the life satisfaction effect of absolute as distinct from relative income. E.g., in the case of Germany, Ferrer-i-Carbonell, Vendrik and Woltjer, and Weinzierl all find no significant effects of absolute income with non-instrumented income. This paper explores to which extent this result may change when using instrumented income.[2]

We employ the German Socio Economic Panel (SOEP) spanning the years 1984-2007 with a focus on Western Germany. First, we make an ordinary least squares (OLS) regression of a dynamic life satisfaction equation which includes contemporaneous and lagged values of noninstrumented household income, actual working hours, social reference income, social reference working hours, and a large number of control variables, as well as fixed individual, time and state effects. Secondly, we estimate this equation with two stages least squares (2SLS), instrumenting household income.

For both estimation methods, we find significant and positive own income effects in the short as well as long run with long run effects being significantly lower than the short-run effects. This implies hedonic adaptation with respect to own income. Under 2SLS both the short and long run coefficients of own income are higher than with OLS. In both cases the coefficients for social reference income show a surprising pattern with a significantly positive quality-of-life effect (Schyns, 2002) in the short run and a significantly negative catching-up-with-the-Joneses effect (Ljunqvist and Uhlig, 2000) in the long run. Together the coefficients for the income variables imply that absolute income has an insignificant effect in the long run under OLS, but that it may have a significant positive effect in the long run under 2SLS.[3] Moreover, in the short run there are strongly significant positive effects of absolute income.

Another surprising finding is that respondents enjoy a strong intrinsic utility of working time (net of leisure) in the short as well as long run. This intrinsic utility reaches maxima for 40 hours per week for men and 34 hours for women in the short run, and for 32 hours for men and 31 hours for women in the long run. Since there are no significant effects of social reference working hours and absolute income is insignificant in the long run, the long-run optimal hours constitute the average social optima in the long run. This implies that especially men work too many hours per week as a consequence of  positional externalities (and hedonic adaptation) with respect to income. Apart from the variation of life satisfaction with working hours, there are also fixed effects of working per se on life satisfaction, which are indicated by the coefficients of employment and involuntary unemployment dummies. Overall there is hedonic reinforcement, i.e. larger long-run than short-run effects, with respect to involuntary unemployment for men and women and with respect to employment for women, but there is hedonic adaptation with respect to employment for men. For the other variables we find hedonic adaptation with respect to birth of children, household type, and marital status. Hedonic reinforcement is found with respect to health satisfaction.

References

Clark, E. A., Frijters, P. and Shields A. M. (2006a) "Income and Happiness: Evidence, Explanations and Economic Implications", Paris-Jourdan Sciences Economiques, Working Paper No. 2006-24.

Clark, A.E., Diener, E., Georgellis, Y. and Lucas, R.E. (2006b), “Lags and Leads in Life Satisfaction: A Test of the Baseline Hypothesis”, IZA Discussion Paper No. 2526, IZA, Bonn.

D’Ambrosio, C. and Frick, J. (2007), “Individual Well-being in a Dynamic Perspective”, IZA Discussion Paper No. 2618, IZA, Bonn.

Ferrer-i-Carbonell, A. (2005), “Income and Well-Being: An Empirical Analysis of the Comparison Income Effect”, Journal of Public Economics, 89: 997-1019.

Layard, R. (2005a), Happiness: Lessons of a New Science, Penguin Books, London.

Layard, R. (2005b), “Rethinking Public Economics: The Implications of Rivalry and Habit”, in: L. Bruni and P.L. Porta (eds.), Economics and Happiness: Framing the Analysis, Oxford University Press, pp. 147-169.

Luechinger, S. (2007), “Valuing Air Quality Using the Life Satisfaction Approach”, Working Paper, University of Zurich, Swiss Federal Institute of Technology.

Ljunqvist, L. and H. Uhlig (2000), ‘Tax Policy and Aggregate Demand Management under Catching Up with the Joneses”, American Economic Review, 90: 356-366.  

Luttmer, E. (2005), “Neighbours as Negatives: Relative Earnings and Well-Being”, Quarterly Journal of Economics, 120: 963-1002.

McBride, Michael (2001) "Relative-Income Effects on Subjective Well-Being in the Cross- Section", Journal of Economic Behavior and Organization, Special Issue July 2001, v. 45, iss. 3, pp. 251-78.

Schyns, P. (2002), “Wealth of Nations, Individual Income and Life Satisfaction in 42 Countries: A Multilevel Approach”, Social Indicators Research, 60: 5-40.

Stevenson, B. and Wolfers, J. (2008), “Economic Growth and Subjective Well-Being: Reassessing the Easterlin Paradox”, IZA Discussion Paper No. 3654, IZA Bonn.

Vendrik, M.C.M. and G. Woltjer (2007), “Happiness and Loss Aversion: When Social Participation Dominates Comparison”, Journal of Public Economics, 91: 1423-1448.

Weinzierl, M. (2006), “Estimating a Relative Utility Function”, Mimeo, Harvard University.

[1] Both authors, Department of Economics, Maastricht University, P.O. Box 616, 6200 MD Maastricht, The

Netherlands, E-mail corresponding author: M.Vendrik@algec.unimaas.nl. Tel. 0031-43-3883638

(3883636). The second author is Research Fellow of IZA.

[2] Such an investigation is the more important since a recent study by Stevenson and Wolfers (2008) on the relationship between economic growth and subjective well-being strongly suggests that absolute income may be a more important determinant of life satisfaction than has been thought so far in the happiness literature.

[3] The significance of these coefficients has yet to be determined.