Little by little, psychology's insights into happiness and well-being are being integrated into economic theory and debate. Happiness has become one of the hot topics in economics over the last decade, with both the size and depth of the literature increasing at a rapid rate.
Though US-based psychologists Daniel Kahneman and Ed Diener and economists Richard Easterlin and Alan Krueger can take much credit, so too can the British 'brat pack' consisting of Warwick's Andrew Oswald, Paris-based Andrew Clark, Dartmouth's Danny Blanchflower and (as an honourary elder statesman), the LSE's Richard Layard. The two Andrews were writing about this stuff years ago, when 'respectable' academic economists thought the topic barking.
What is particularly encouraging is that economists are starting seriously to tackle the major empirical and the theoretical challenges that this literature has uncovered. A new paper by Andrew Clark, Paul Fritjers and Michael A Shields, prepared for the Journal of Economic Literature, ups the ante. Relative Income, Happiness and Utility: An Explanation for the Easterlin Paradox and Other Puzzles (PDF) takes as its starting point Easterlin's seminal 1974 paper which posed a paradox - that happiness does not appear to increase with income, once basic needs are fulfilled. The paper covers a lot of ground, including adaptation, social comparisons, relative income, utility and much more besides. There is a short but insightful description of the key challenges for empirical work. And to wrap it up, the authors explore some implications for economic theory and policy design. As a sampler, here are the authors concluding remarks:
The interaction between economic theory and happiness is therefore the next milestone for the developing economics of happiness literature. However, it is clear that the empirical literature on happiness still faces several challenges, many of which are shared with other empirical literatures. Two of the key challenges are to deal with a general inability of survey data to precisely time changes in income with changes in happiness over long time periods, and the difficulty in mapping incomes into current and expected consumption. It is also the case that most datasets do not contain reliable (if any) ex ante information regarding the group (the reference point) to which individuals compare themselves. Similarly, no dataset can contain all the variables of importance, so that researchers will continue to face the issue of endogeneity with respect to income and other variables such as marriage, education, and the reference group. Finally, natural experiments producing exogenous variation in income are only rarely observed, making the issue of establishing the causal effect of income on happiness a major challenge.
Our final conclusion is that taking relative income seriously is an important step towards greater behavioural realism in Economics, such that our models and empirical analysis move closer to how real people feel and behave. Some may not like the insertion of additional arguments into individual utility, and remark that any behaviour can be rationalised by an appropriate manipulation of the utility function. While this is formally true, it does not apply wholesale to the issue of relative income. As we have tried to demonstrate, utility functions including relative income terms produce a wide variety of testable predictions regarding both well-being (measured by survey or neurologically) and observable behaviours: it is not true that “anything goes”. To our mind, this is precisely why we need to appeal to both direct measures of utility and observed behaviour in order to obtain a better idea of what the utility function looks like, and make policy recommendations in the best interest of society. Testing these predictions not only allies theory and empirical analysis in economics, it also spills across many disciplines in the social and natural sciences; it is arguably the most important and the most promising of the research avenues open to this thriving literature.
This is no light summer reading, but for those seeking to advance the debate, it's a big step forward.