Happiness, Adaptation, and Decreasing Marginal Utility of Income

By Lee, Dwight R. | Journal of Private Enterprise, Fall 2011 | Go to article overview
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Happiness, Adaptation, and Decreasing Marginal Utility of Income


Lee, Dwight R., Journal of Private Enterprise


Abstract

Happiness studies both support and question diminishing marginal utility of income. Cross-sectional studies support the proposition that marginal utility of income declines with income, but longitudinal studies indicate that marginal utility of income is zero once basic needs are met. Adaptation to income increases has been used to reconcile these two empirical results. This seems to suggest that the marginal utility of income decreases in the short run, but not in the long run, over a wide range of income in wealthy countries. Making use of loss aversion, however, it is shown that income transfers from the rich to the poor are likely to reduce total utility in the short run while having no long-run effect.

JEL Codes: D31, D63, H24

Keywords: Adaptation; Happiness; Income marginal utility; Transfers

I. Introduction

It has long been argued that transferring income from the rich to the poor increases total utility (or happiness) because of decreasing marginal utility of income. Of course, before income equality is achieved, further transfers reduce income growth by enough to offset any additional utility gain from reducing further the marginal utility gap between the rich and poor. The proposition that a poor person receives a larger utility gain from an additional dollar than a rich one is intuitively plausible. Yet, the rapidly expanding happiness research initiated by Easterlin (1974) finds empirical patterns that both support and question the view that the marginal utility of income decreases as income increases. Cross-sectional data, both within and across particular countries, support decreasing marginal utility of income - in the short run there is a positive, but diminishing, relationship between income and happiness. On the other hand, time-series data from a number of countries show that increased income within countries has no noticeable long-run effect on average happiness or utility. This has become known as the Easterlin paradox.

Despite this ambiguity between the short- and long-run effects on the marginal utility of income, some scholars have not hesitated to use happiness studies to support income transfers from the richer to poorer as a way of increasing total utility. For example, Layard (2005, p. 52) states, "if money is transferred from a richer person to a poorer person, the poor person gains more happiness that the rich person loses. So average happiness increases." And according to Griffith (2004, p. 1363), "[sjtudies show the level of inequality in a society also may affect levels of happiness. Ultimately, happiness research is consistent with the strongest justification for adopting a progressive tax structure - income has declining marginal utility, thus redistribution can increase total welfare in a society." On the other hand, based on the time-series evidence, Easterlin (2005, p.252) puts forth for consideration the proposition that over the long run, "[i]nstead of diminishing marginal utility of income, there is zero marginal utility."

In this paper I incorporate a finding by behavioral economists on loss aversion into a consideration of the short- and long-run effects of income on happiness. I reach the rather surprising conclusion that the diminishing marginal utility argument for reducing income inequality is weaker in the short run than in the long run. Indeed, it possible that the short-run happiness losses to those with higher incomes exceed the short-run happiness gains to those with lower incomes when money is transferred from the former to the latter.

In the next section I discuss briefly how adaptation has been used to reconcile the difference in the cross-sectional and time-series data from the happiness literature and how income becomes less useful as a proxy for happiness as a country becomes wealthier. This leads into the primary purpose of the paper in Section III, where I incorporate adaptation and loss aversion (or endowment effect) into a simple diagram to demonstrate that the possibility of improving happiness, even in the short run, with income transfers is more limited than commonly believed.

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