Monday, June 14, 2010

Relative Consumption

Which would you choose?

The first choice is between World A, in which you live in a 4,ooo-square-foot house and others live in 6,ooo-square-foot houses; and World B, in which you live in a 3,000-square-foot house and others in 2,000-square-foot houses.

According to the standard neoclassical economics, which holds that utility depends on the absolute amount of consumption, the correct choice is World A. For if absolute house size is all that matters, A is indeed a better world for all, since everyone has a larger house there than the largest house in World B. The important thing, though, is to focus on how you would feel in the two worlds.

In fact, most people say they would pick B, where their absolute house size is smaller but their relative house size is larger. Even those who say they would pick A seem to recognize why someone might be more satisfied with a 3,000-square-foot house in B than with a substantially larger house in A. If that is true for you as well, then you accept the main premise required for the arguments I will present.

In the second thought experiment, your choice is between World C, in which you would have four weeks a year of vacation time and others would have six weeks; and World D, in which you would have two weeks of vacation and others one week. This time most people pick C, choosing greater absolute vacation time at the expense of lower relative vacation time.

I use the term positional good to denote goods for which the link between context and evaluation is strongest and the term nonpositional good to denote those for which this link is weakest. In terms of the two thought experiments, housing is thus a positional good, vacation time a nonpositional good. The point is not that absolute house size and relative vacation time are of no concern. Rather, it is that positional concerns weigh more heavily in the first domain than in the second.

Arguments to present:

1. People care about relative consumption more in some domains than in others. Or, to put this proposition in more neutral language, context matters more in some domains than in others. The two thought experiments just discussed illustrate this proposition. Although context matters for evaluations of both housing and leisure time, it matters more for evaluations of housing.

2. Concerns about relative consumption lead to “positional arms races” or expenditure arms races focused on positional goods. In the context of the two thought experiments, this proposition says that individuals will work longer hours to earn the money that will enable them to buy larger houses, expecting to enjoy the additional satisfaction inherent in owning a relatively large house.

3. Positional arms races divert resources from nonpositional goods, causing large welfare losses. When people contemplate working longer hours to buy larger houses, they anticipate additional satisfaction not only from having a larger house in absolute terms, but also from having a larger house in relative terms. For the move to appear attractive, the anticipated sum of these two gains must outweigh the loss in satisfaction associated with having fewer hours of leisure. When all make the same move in tandem, however, the distribution of relative house size remains essentially as before. So no one experiences the anticipated increase in relative house size. When the dust settles, people discover that the gain in absolute house size alone was insufficient to compensate for the leisure that had to be sacrificed to get it. Yet failure to buy a larger house when others do is not an attractive option for the individual, either. As in the familiar stadium metaphor, all stand to get a better view, but when all stand no one sees better than when all were seated.

4. For middle-class families, the losses from positional arms races have been made worse by rising inequality. In recent decades, most of the income gains in the United States have gone to people at the top of the income distribution. Not surprisingly, their higher incomes have led these people to build larger houses. There is little evidence that middle-class families envy the good fortune of the wealthy. Yet the larger houses at the top have led families in the middle to spend sharply higher fractions of their incomes on housing, in the process forcing them to curtail other important categories of spending.

- Robert Frank

Which line is longer?

Answer: Same

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