New Evidence on Reference Effects from IZA Working Paper

From IZA Working Papers

Economic Satisfaction and Income Rank in Small Neighbourhoods
by Andrew E. Clark, Nicolai Kristensen, Niels Westergård-Nielsen
(November 2008)
forthcoming in: Journal of the European Economic Association

Abstract:
We contribute to the literature on well-being and comparisons by appealing to new Danish data dividing the country up into around 9,000 small neighbourhoods. Administrative data provides us with the income of every person in each of these neighbourhoods. This income information is matched to demographic and economic satisfaction variables from eight years of Danish ECHP data. Panel regression analysis shows that, conditional on own household income, respondents report higher satisfaction levels when their neighbours are richer. However, individuals are rank-sensitive: conditional on own income and neighbourhood median income, respondents are more satisfied as their percentile neighbourhood ranking improves. A ten percentage point rise in rank (i.e. from 40th to 20th position in a 200-household cell) is worth 0.11 on a one to six scale, which is a large marginal effect in satisfaction terms.

What does income matter?

Income determines what we can consume. We get if from working, from others, from reaping past investments etc., Does it do us any good? A recent paper alluded to in an earlier post attempts to debunk the Easterlin hypothesis. This paper is much more closely aligned to how we traditionally think of income: namely more is better controlling for the effort required to obtain it.

However, there is also a huge literature that attempts to examine more subtle motivations that link income to well-being. There have been many other attempts to explore the well-being pay-off from income. One strand of the literature essentially posits income as a component of a zero-sum game. Reference-dependency is viewed as a key motivation for acquiring income and a key mediator of how much benefit we derive from the income we have. Papers by McBride, Clark and Oswald and others makes this case forcefully. Recent work by Mary Daly and colleagues even claims that such negative reference effects may underpin the link between suicide and income. Senik's paper below makes a slightly more complex point that sometimes it might be good to see your reference group get ahead as it acts as a good sign for your own prospects but the general view in the literature is that seeing people like you getting ahead increases the pressure on you and dampens the well-being increments from increasing levels of income.

McBride Paper

Daly et al Suicide Paper

Senik Paper

As well as reference dependency with respect to others, reference dependency with respect to ourselves through time is also considered in a number of papers as a key aspect of how income enters in to our utility. Burchardt and colleagues have verified the preference for ascending sequences in work using the British Household Panel Survey. This type of work is important as we get to grips with a potential recession in many countries.

Burchardt Paper

As several countries face slowdowns it raises some fundamental questions of how people evaluate their income and convert this evaluation in to more general well-being. Do we process merely absolute income (the literature would say no)? Which reference groups do we compare ourselves to and is there some element of choice in how we do this? How do we evaluate our position through time? Which time periods of our life are given most salience? For example, surely people could simply reason that despite the slowdown they are better off than ten years ago even if worse off than last year? Why would some time-reference points be more salient than others? How do personality and motivation affect the relationship between income fluctuations and well-being fluctuations?