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Consumption externalities occur when consumption by some creates external costs or benefits for others. Their recognition by economists dates at least as far back as Adam Smith’s discussion of how local consumption standards influence the goods that people consider essential (or ‘necessaries’, as Smith called them). In the following passage, for example, he described the factors that influence the amount someone must spend on clothing in order to be able appear in public ‘without shame’:

By necessaries I understand, not only the commodities which are indispensably necessary for the support of life, but whatever the custom of the country renders it indecent for creditable people, even of the lowest order, to be without. A linen shirt, for example, is, strictly speaking, not a necessary of life. The Greeks and Romans lived, I suppose, very comfortably, though they had no linen. But in the present times, through the greater part of Europe, a creditable day-labourer would be ashamed to appear in publick without a linen shirt, the want of which would be supposed to denote that disgraceful degree of poverty which, it is presumed, no body can well fall into without extreme bad conduct. (Smith 1776, pp. 869–70)

Consumption externalities received only limited attention in Smith’s Wealth of Nations and only occasional mention by economists during the century that followed its publication. Karl Marx (1847), for example, noted that ‘A house may be large or small; as long as the neighboring houses are likewise small, it satisfies all social requirement for a residence. But let there arise next to the little house a palace, and the little house shrinks to a hut.’

It was not until Thorstein Veblen’s The Theory of the Leisure Class appeared in 1899 that consumption externalities received their first serious, book-length treatment in economics. Veblen’s thesis was that much of consumption is undertaken to signal social position. But although his book is still widely read and cited by scholars in numerous disciplines, its general theme was largely ignored by economists during the 50 years following its publication.

Duesenberry’s Relative Income Hypothesis

Interest in this theme was rekindled with the publication of James Duesenberry’s Income, Saving, and the Theory of Consumer Behavior in 1949. In this volume, Duesenberry offered his ‘relative income hypothesis’, in which he argued that an individual’s spending behaviour is influenced by two important frames of reference – the individual’s own standard of living in the recent past and the living standards of others in the present. Thus, in Duesenberry’s account, people are subject to both intrapersonal and interpersonal consumption externalities.

His theory attempted to explain three important empirical regularities: (a) long- run aggregate savings rates remain roughly constant over time, even in the face of substantial income growth; (b) aggregate consumption is much more stable than aggregate income in the short run; and (c) individual savings rates rise substantially with income in cross-section data. When Duesenberry’s book was first published, individual consumption was generally modelled by economists as a linear function of income with a positive intercept term. This model could accommodate rising savings rates in cross-section data and the stability of consumption over the business cycle, but not the long-run stability of aggregate savings rates.

Duesenberry’s hypothesis was hailed as an advance because of its ability to track all three stylized fact patterns. The poor save at lower rates, he argued, because they are more likely to encounter others with desirable goods that are difficult to afford. Moreover, since this will be true no matter how much national income grows, unfavorable comparisons will always occur more frequently for the poor – and hence the absence of any tendency for savings rates to rise with income in the long run.

To explain why consumption is more stable than income in the short run, Duesenberry argued that families compare their living standards not only to those of others around them but also to their own standards from the past. The high consumption level once enjoyed by a formerly prosperous family thus constitutes a frame of reference that makes cutbacks difficult when income falls.

Despite Duesenberry’s success in tracking the data, many economists felt uncomfortable with his relative income hypothesis, which to them seemed more like sociology or psychology than economics. The profession was therefore immediately receptive to alternative theories that purported to explain the data without reference to softer disciplines. The most important among these theories was Milton Friedman’s permanent income hypothesis, variants of which still dominate today’s research on spending.

In hindsight, however, there remain grounds for scepticism about whether Friedman’s theory was a real step forward. For example, its fundamental premise – that savings rates are independent of permanent income – has been refuted by numerous careful studies (see, for example, Carroll 1998). Some modern consumption theorists have responded by positing a bequest motive for rich consumers, a move that begs the question of why leaving bequests should entail greater satisfaction for the rich than for the poor.

Another problem is that, contrary to Friedman’s assertion that the marginal propensity to consume out of windfall income should be nearly zero, people actually consume such income at almost the same rate as permanent income (Bodkin 1959). To this observation, Friedman (1963) himself responded that consumers appear to have unexpectedly short planning horizons. But if so, then consumption does not really depend primarily on permanent income.

Abundant evidence suggests that context influences evaluations of living standards (see, for example, Veenhoven 1993; Easterlin 1995; Luttmer 2005). In the light of this evidence, it seems fair to say that Duesenberry’s hypothesis not only has been more successful than Friedman’s in tracking how people actually spend but also rests on a more realistic model of human nature. And yet the relative income hypothesis is no longer even mentioned in most leading economics textbooks. Its absence appears to signal the profession’s continuing reluctance to acknowledge concerns about relative consumption.

Welfare Implications

In traditional economic models, individual utility depends only on absolute consumption. These models lie at the heart of claims that pursuit of individual selfinterest promotes aggregate welfare. In contrast, models that include concerns about relative consumption identify a fundamental conflict between individual and social welfare. This conflict stems from the fact that concerns about relative consumption are stronger in some domains than in others. The disparity gives rise to expenditure arms races focused on ‘positional goods’ – those for which relative position matters most. The result is to divert resources from ‘non-positional goods’, causing welfare losses. (The late Fred Hirsch 1976, coined these terms.)

The nature of the misallocation can be made clear with the help of two simple thought experiments. In each, you must choose between two worlds that are identical in every respect except one. The first choice is between world A, in which you will live in a 4,000-square-foot house and others will live in 6,000-square-foot houses; and world B, in which you will live in a 3,000-square-foot house, others in 2,000-square-foot houses. Once you choose, your position on the local housing scale will persist.

If only absolute consumption mattered, A would be clearly better. Yet 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.

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, others one week. This time most people pick C, choosing greater absolute vacation time at the expense of lower relative vacation time.

The modal responses in these two thought experiments suggest that housing is a positional good and vacation time a non-positional 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.

When the strength of positional concerns differs across domains, the resulting conflict between individual and social welfare is structurally identical to the one inherent in a military arms race. When deciding how to apportion available resources between domestic consumption and military armaments, each country’s valuations are typically more context-dependent in the armaments domain than in the domain of domestic consumption. After all, being less well armed than a rival nation could spell the end of political independence. The familiar result is a mutual escalation of expenditure on armaments that does not enhance security for either nation. Because the extra spending comes at the expense of domestic consumption, its overall effect is to reduce welfare. Note, however, that if each country’s valuations were equally context-sensitive in the two domains, there would be no arms race, for in that case the attraction of having more arms than one’s rival would be exactly offset by the penalties of having lower relative consumption.

For parallel reasons, the modal responses to the two thought experiments suggest an equilibrium in which people consume too much housing and too little leisure (for a formal demonstration of this result, see Frank 1985a). In contrast, conventional welfare theorems, which assume that individual valuations depend only on absolute consumption, imply optimal allocations of housing and leisure.

In addition to leisure, goods that have been classified as non-positional by various authors include workplace safety, workplace democracy, savings and insurance. And since public goods are, by definition, available in equal quantities to all consumers, they, too, are inherently non-positional. The general claim is that unregulated market exchange will tend to emphasize the production of positional goods at the expense of these and other non-positional goods (Frank 1985b). Among the policies suggested as remedies for this imbalance have been income and consumption taxes, overtime laws, hours laws for commercial establishments, legal holidays, workplace safety and health regulation, non-waivable workers’ rights, and tax-financed savings accounts.

Consumption externalities also have implications for the theory of revealed preference, which says that, if a well-informed individual chooses a risky job that pays $600 a week rather than a safer one that pays only $500, he reveals that the safety increment is worth less than $100 to him. If safety is a non-positional good, however, this inference does not follow, for it ignores the fact that, if all workers exchange safety for increased income, the anticipated increase in relative consumption does not occur. The value that workers assign to safety may thus be revealed as much in the patterns of safety regulation they favour as in the nature of the jobs they choose.

See Also