The Animal Spirits of Inequality: Why Relative Earnings Matter

Men do not desire to be rich, but to be richer than other men.” – John Stuart Mill

     Income inequality: Sophomoric idea to some, grave injustice to others. The widening gap between society’s rich and poor has shaped societal ideologies and fuelled political movements. People are tired of the fact that the wealthy 1% of the world own all the resources. The oft-quoted 2017 Oxfam report about how 8 men own as much wealth as the poorest 50% of the world has become a rallying outcry among the masses. There is a call to income redistribution and stricter capital tax measures. Socialist populist leaders like Bernie Sanders are gaining traction for the simple reason that people feel that the wealth divide is a crude reflection of a dichotomous society. Amongst all this hustle and bustle, cognitive psychologist and self-professed admirer of free market economics, Steven Pinker, raises an interesting question – Why do people care about the proportion of the pie slices when the overall size of the pie is increasing? People should be more optimistic right? People with that frame of mind regard inequality as the wrong aspect to focus towards. Traditional economics dictates that our real concern should be to increase our absolute income. What other people earn should be of little significance to us. There’s just one slight issue. Most of neo-classical economics is based on a key assumption: People are rational. But then again, have you met people? Enter: Behavioural Economics.

Rational economic behaviour, in as colloquial terms as I can put it, dictates that given certain choices, people make logical and meticulous decisions after weighing out all the pros and cons of the subsequent outcomes, in an effort to maximise their own personal utility. In the book Animal Spirits, authors George A. Akerlof and Robert J. Shiller criticize traditional economists because they fail to recognize the psychological motivations in people’s minds that govern irrationality. People are driven by animal spirits (a term coined by John Maynard Keynes) which influence their behaviour in ways that go against robotic judgement. One of these animal spirits is fairness. People like to be treated fairly and in a manner that they best deem as just. This entails equality in rights and opportunities, impartial treatment and of course equality in wages for equal performance – Equity theory. Those who advocate socialism often bring to call the unfairness in the wealthy classes enjoying all the fruits of the labour of the poor. At the risk of sounding like a Marxist, the employees put in most of the work, and the employers enjoy most of the profits. These economic rents and benefits are seen as undeserved and imbalanced. Since the wealthy are also influential through lobbying and structuring financial systems, this only leads to an inequality spiral wherein the rich get richer and the poor get poorer.

In addition to fair compensation between principal and agent, employees would like fair compensation for the input they provide. ‘The Fair Wage-Effort Hypothesis and Unemployment’ (Akerlof, George A. and Yellen, Janet A., 1990) talks about how employees are only willing to supply a full potential effort of ‘e’ when their actual wage w, is over and above the perceived fair wage of w* such that

e=min(w/w*,1)

The paper further goes on to quote Carroll and Tosi (1977, p. 303) – “Pay satisfaction is influenced by what an individual gets as compared to what he wants and considers fair. The fairness of pay (perceived equity of pay) is determined largely by an individual’s comparison of himself and his pay to other reference persons and theirs [sic].” With no accurate measure to judge the ratio of input to output, employees tend to rely on comparative measures amongst colleagues to determine whether the wages they receive are fair, thus impacting their own personal utility. Asymmetric information has led to relative earning being treated as a signal for fairness.

For a long time, economists have assumed that an individual’s utility is dependent on their own consumption U(C). However, in the 20th century, one economist proposed introducing an additional variable into the equation: Relative Consumption i.e. C̅ resulting in U(C, C̅).

This theory is known as the relative income hypothesis and was put forth by James Duesenberry who in 1949 was already paving the way for behavioural economics. The utility one derives from consumption depends on what and how much one consumes relative to what others consume. In a paper titled ‘James Duesenberry as a practitioner of Behavioural Economics’ (McCormick, Ken, 2018) ,McCormick notes how Duesenberry challenged neo-classical assumptions of independent consumer preferences and highlighted ideas now common in behavioural economics like the spotlight effect and interdependent preferences through theories like the Relative Income Hypothesis. This theory however is mostly overlooked for the more popular Permanent Income Hypothesis and its idea of consumption smoothing. Theories like Duesenberry’s were brushed aside in history by economists simply because they failed to acknowledge the rationality of individuals. Why should relative consumption matter so much, when absolute consumption increases. The Permanent Income Hypothesis instead stressed upon far-sightedness and self-control. These characteristics were presumed to be more akin to the rational, self-serving robots economists thought people were. (To use John Stuart Mill’s popular euphemism: Homo Economicus)

A research paper by titled ‘Neighbors as Negatives: Relative Earnings and Well Being’ (Luttmer, E, 2005) tried to test the ideas behind relative consumption through an empirical approach. Luttmer used the data from the National Survey of Family and Households, over two periods (1987-88 and 1992-94) and utilized an OLS regression model to see if self-reported happiness depends on relative income in addition to one’s own income.

Well-being=  f(own income, average income in locality, controls)

Luttmer found that relative earnings do in fact have a positive co-relation with one’s happiness. He references a scenario in which a man who receives an increase in his income relocates to a more affluent neighbourhood. This man will hypothesize that since he’s better off compared to his previous neighbours, a shift to a new area will result in positive externalities for himself. However, while this may bring him momentary happiness, it will prove to be short-lived. He now has an entirely different frame of reference to judge his own well- being. His neighbours will have more expensive cars, send their children to more exclusive schools and go on dates to fancier restaurants. While his income may have increased in absolute terms, his relocation has resulted in a decrease in his relative income.

Psychologically, human beings are hierarchical creatures. Our status and position in society is incredibly important. Day to day interactions amongst both contemporaries and adversaries are thought of in terms of a zero-sum game. The only way for me to gain a raise is for HR to see and recognize that Shelly from sales has been slacking off lately. Perhaps one of the reasons inequality is such a crucial issue for us is because wealth is perceived as finite, or at least limited. For every 1 billionaire, the amount of mouths that could be fed is innumerable. From a utilitarian perspective, wouldn’t it be better to feed the many at the cost of the few? From an economics perspective, isn’t the marginal benefit of an increase in income significantly greater for the poor than it is for the wealthy classes? Or are we in the moral wrong for ostracising the rich few who want an increase in economic rents?

Income inequality, in my opinion, is the predominant economic concern of our times. Everyone from Steven Pinker to Joseph Stiglitz has had their say. However, traditional economics has always side-lined the inequality problem and claimed that it is merely a symptom of the real issue: absolute poverty. Behavioural economics aims to cast doubts on this conjecture and raise a counter-argument. While the theories mentioned above may have their caveats, and seem insufficient to analyse inequality on a macro level (think incentives for neoliberals), the fact still remains. People do not just care about their own income and consumption, they think with different frames of reference. Relative income and relative consumption are equally influential on utility, because we’re not Homo Economicus. We have those darn animal spirits.


Calvin Paperwala is a research executive at a market research consultancy in the U.A.E. He did his undergraduate degree in Economics and Management from the University of London: International Programme.

References

Akerlof, G. and Shiller, R. 2010. Animal spirits. Princeton, NJ: Princeton Univ. Press.

Akerlof, George A. and Yellen, Janet L., 1990. The Fair Wage-Effort Hypothesis and Unemployment, The Quarterly Journal of Economics 105 (2): 255-283

Berg, Nathan, 2006. Behavioral Labor Economics, MPRA Paper 26366 (4)

Frakt, A. and Jamison, J. 2009. Income Inequality and Behavioral Economics. [online] The Incidental Economist. Available at: https://theincidentaleconomist.com/wordpress/income-inequality-and-behavioral-economics/

Luebker, Malte, 2014. Income Inequality, Redistribution, and Poverty: Contrasting Rational Choice and Behavioral Perspectives, Review of Income and Wealth 60 (1): 133-154

Luttmer, Erzo F. P. 2005, Neighbors as Negatives: Relative Earnings and Well-being, The Quarterly Journal of Economics 102 (3): 963-1002

McCormick, Ken, 2018. James Duesenberry as a practitioner of behavioural economics, Journal of Behavioral Economics for Policy 2 (1): 13-18

Nishi, A and Christakis, Nicholas A. 2015. Human behaviour under economic inequality shapes inequality [online] PNAS. Available at https://www.pnas.org/content/112/52/15781

Oxfam. 2017. An Economy for the 99%: It’s time to build a human economy that benefits everyone, not just the privileged few (Oxfam Briefing Paper January 2017). Retrieved from https://www-cdn.oxfam.org/s3fs-public/file_attachments/bp-economy-for-99-percent-160117-en.pdf

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