Tuesday, August 16, 2005

Keeping Up With the Joneses: Relativity Theory Revisited

Would you prefer to earn $100,000 a year and live in a community where everyone else earns $75,000 a year or to earn $150,000 a year and live in a community where everyone else earns $200,000 a year? More concisely, is your own thermometer of your own well being a function of your absolute level of income or relative income compared to your peer group?

The public policy implications of these questions are obvious. If we are jealous “relativists” then a growing macro economy in which income inequality is rising could lower aggregate well-being! When I taught intro economics at Columbia University, I used to crack a bad joke about relativity. “During war time, if your house is ½ destroyed by bombs while your neighbors’ homes are destroyed are you going to tell me that you are now happier?” Looking back, I should have done a better job making the case for and against the “relativity” hypothesis. When I was a graduate student at the University of Chicago, the consumers we studied were not envious. They gained utility solely from their own consumption and only cared about their own household’s expected present value of earnings.

Recently, empiricists have been exploring the “relativity hypothesis”. I post this as part of my Urban Economics blog because most peer groups are defined spatially by one’s residential community. Consider Erzo Luttmer’s recent paper “Neighbors as Negatives”.
“This paper investigates whether individuals feel worse off when others around them earn more. In other words, do people care about relative position and does lagging behind the Joneses' diminish well-being? To answer this question, I match individual-level panel data containing a number of indicators of well-being to information about local average earnings. I find that, controlling for an individual's own income, higher earnings of neighbors are associated with lower levels of self-reported happiness. The data's panel nature and rich set of measures of well-being and behavior indicate that this association is not driven by selection or by changes in the way people define happiness. There is suggestive evidence that the negative effect of increases in neighbors' earnings on own well-being is most likely caused by interpersonal preferences people having utility functions that depend on relative consumption in addition to absolute consumption.”

A second example of this type of empirical work was published in the 8/16/2005 Science Section of the New York Times in Eric Nagourney’s Vital Signs section. He cites some sociologists (Firebaugh and Tach) who use the General Social Survey. This survey asks 16000 people ages 20 to 64; “are you happy?” Taking people’s answers seriously, these researchers run a regression to estimate a happiness production function. Controlling for a person’s age, physical health, education and other factors, if people who are the same age as the respondent are richer, then the person is predicted to be less happy. This study strikes me as a little bit weird that the “peer group” is everyone your age. This is quite a different peer group then looking at the set of people who live within 2 miles of your house. I’m 39 years old and I’m trained in labor economics but I only have a vague guess concerning what is the average income of other 39 year olds throughout the United States. If I don’t know their average income, can this really affect my happiness?

Luttmer’s empirical design (presented above) strikes me as a much beter way to test the relativity hypothesis than what Firebaugh and Tach have cooked up. Unlike these sociologists, he is able to exploit spatial differences in peer groups.

But, the fundamental weakness in this literature is addressing heterogeneity. Put simply, people differ with respect to their envy. If Matt is very envious person and he knows this, he should “pick his pond” and migrate to an area where he is above average. If Matt is not an envious person, he can be the poorest person on his block and this doesn’t bug him. The advantage of being the poorest person on your block is that your neighbors are paying more in property taxes and you have access to the same local public services such as public schools as they do.

As an empiricist, I would propose the following hedonic real estate pricing test. Do smaller homes in rich communities sell for a lower price than the same home if it is located in a middle class community. If “relativity” is really true for most people, then the small home should sell for a discount in the rich community. I doubt the data will support his proposition.

In joint research with Pat Bajari of University of Michigan we have been studying the demand for single detached homes in Los Angeles County over the years 2000 to 2003. I took our whole sample of 165,000 homes and kept only the small homes. These are homes whose interior square footage is less than the 25th percentile of the entire distribution. I then ran a regression for 39,957 homes of the log(sales price of the home) as a function of the home’s age, interior square feet, exterior square feet, population density in the home’s census tract, average commute time and distance to the Central Business District. Controlling for all of these variables, I find that an extra $10,000 in median household income on the census block where the home is located raises the price of the small home by 12.7%. This is quite suggestive evidence against the “relativity” hypothesis. Again, small homes have a higher equilibrium price when they are in richer communities. Since the people who buy the small homes are likely to be poorer then their neighbors, my finding beats on the “relativity” hypothesis.

I am hopeful that economists will continue to study how emotions affect our behavior. I have written one paper on shame. A recent version is posted at: http://web.mit.edu/costa/www/papers.html