Thursday, November 30, 2006


Conference on Quality of Life, Deakin University
November 30, 2006

I want to talk to you about the increased interaction between the disciplines of psychology and economics, and focus particularly on the relationship been income and subjective wellbeing, as befits a conference on quality of life. But first I need to explain that I’m not an economist myself. Rather, I’m a journalist who writes about economics.

Psychology and economics

You won’t be surprised to know that the academic discipline of economics is pretty inward-looking and hidebound. It’s still dominated by the neoclassical model of markets developed first by economists such as Adam Smith in the 18th century and Alfred Marshall in the 19th. It’s evolved a bit since then, but not as much as you might expect and not as much as I suspect psychology has. The conventional neoclassical model is built on many debatable assumptions, but most of the academic effort has gone not on trying to improve those assumptions but on mathematising the model, which permits many rigorously logical conclusions to be drawn - given the assumptions. All this maths allows the economists - like psychologists - to believe their discipline is more rigorously scientific than the other social sciences.

There have been various new developments in economics over the years - most of which have come to dead ends - but the relatively recent developments I find most interesting and most promising are based on borrowings from the work of psychologists. It may surprise you to know that the Nobel Prize in economics has twice been won by psychologists. Herb Simon of Carnegie-Mellon won it in 1978 for his ‘pioneering research into the decision-making process within economic organisations’. Conventional economics assumes economic man - homo economicus - to be a lightning-quick calculator of costs and benefits. Simon argued that people often use rules of thumb that economise on the cost of collecting information and on the cost of thinking. Their rationality was thus ‘bounded’ and rather than maximising their utility they ‘satisfice’ - they do as well as they think possible.

The second Nobel to a psychologist went to Daniel Kahneman of Princeton in 2002. He took Simon’s work a lot further, winning the prize ‘for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty’. It’s not directly relevant to quality of life, but I’ll say a little about it because it is interesting and it does, at present anyway, represent psychology’s most successful incursion into the thinking of economists. With the help of some economists, Kahneman founded a new school of thought within economics, known as behavioural economics, which has attracted a big following among younger academics.


As we’ve seen, behavioural economics challenges one of the central elements of conventional microeconomic theory: the assumption of Homo economicus. Economic man is assumed to be rational and self-interested. She always carefully evaluates all the options before making any decision, and always with the object of maximising her personal ‘utility’ or satisfaction. But cognitive psychologists have demonstrated that humans simply lack the neural processing power to make the carefully calculated decisions economists assume. People aren’t rational, they are intuitive. And altruism is often an important consideration in their decision-making. People can’t chose correctly between three options where the best option is not immediately apparent. Rather than carefully thinking through the pros and cons of every decision, people tend to rely on mental shortcuts (‘heuristics’) which often serve them well enough, but also lead them into systematic biases. People are often slow to learn from their mistakes. They are frequently capable of reacting differently to choices that are essentially the same, just because the choices have been ‘framed’ differently. This means that, rather than being coldly rational, people’s decisions are often influenced by emotional considerations.

All this means that Homo sapiens differs from Homo economicus in many important respects. He doesn’t conform to economists’ assumption of fungibility (one dollar is indistinguishable from another), he is often not bothered by opportunity cost and thus has a strong bias in favour of the status quo. He doesn’t ignore ‘sunk costs’ as he is supposed to and often cannot order his preferences consistently. He is not averse to risks so much as averse to losses and he focuses more on changes in his wealth than on its absolute level.

Unlike Homo economicus, Homo sapiens cares deeply about fairness. Experiments show people will walk away from deals they consider treat them unfairly, even though those deals would leave them better off. People are prepared to pay a price to punish others they consider to have been behaving badly towards the group. Often people are concerned about ‘procedural fairness’ – how things are done, not just how they end up.

Wellbeing and utility

That’s enough about psychology’s first challenge to economic orthodoxy. After Kahneman had made his mark on the theory of decision-making he moved on to join many other psychologists - and a few pioneering economists - in studying subjective wellbeing, quality of life, life satisfaction, happiness, call it what you will. This study ought to be of intense interest to economists because it’s hard to see much difference between psychologists’ subjective wellbeing and economists’ utility or satisfaction. In original intention, neoclassical economics is about studying the way individuals maximise their utility. As you know, conventional economics was heavily influenced by Bentham’s utilitarianism. So if economics has a goal, it’s to help the community maximise its utility.

The problem is that economics has rather lost its way on the question of utility. Sometime in the 1930s it was decided that the trouble with utility is that it’s unobservable - you can’t measure it. You can’t know how much utility A derives from the consumption of a glass of beer relative to B. The most we can hope to know is how they order or rank their choices. A prefers beer to wine, but wine to lemonade. But no mater. Since A and B are rational, and are always seeking to maximise their utility, it’s clear their preferences will be revealed simply by looking at what they choose to buy with their income. Their ‘revealed preference’ will tell us all we need to know about their utility.

Note how this seemingly neat shortcut relies heavily on the assumption of rational choice, that people always know and do exactly what’s best for them. They never do anything they subsequently regret and if occasionally they make a mistake, they quickly realise their error and never repeat it. Note, too, how circular the logic has become. How do we know what people want? From what they do. How do we know they do what they want? Because they do it. And here we see an old prejudice among economists that affect their attitudes towards psychology and its experiments, as well as surveys of wellbeing: ignore what people say they want, just focus on what they do. The other short-circuitry at work is that, though in theory economics is about maximising utility, in practice it ends up being about maximising consumption. Which particular forms of consumption? Doesn’t matter - just consumption. Which consumption is the private business of each consumer and not a fit subject for economists or governments to meddle with. How do you maximise consumption? By maximising the income from which people finance their consumption. How do you do that? By getting the economy to grow as fast as you reasonably can.

Now perhaps you see why the psychologists’ huge body of work on wellbeing is highly relevant to the work of economists - and highly challenging to their conventional views. And the particular pressure-point is obvious: the relationship between income and wellbeing. That’s what the economists who study wellbeing are most interested in. So what have we discovered about income’s role in wellbeing? We’ll get to that in a moment, but first I want to say something about terminology.

Speaking the same language

I think there’s much to be gained from an inter-disciplinary approach to many issues, but I’m constantly disappointed by the lack of contact between academics of different disciplines. They often criticise each other from afar - from the comfort of their own camps - but rarely get together to argue through issues of common interest. As a result, they’re often quite ignorant of the others’ way of looking at things, thus allowing much misunderstanding and incomprehension.

Joan Robinson, perhaps the most famous female economist and a contemporary of Keynes at Cambridge, once said that the purpose of studying economics is to learn how to avoid being deceived by economists. My take on the subject isn’t so defamatory: I think we study economics to learn when to use the many synonyms for the word ‘money’. Money is a vague term, can’t you be more specific? I’ve noticed that many social scientists use the words ‘income’ and ‘wealth’ interchangeably, whereas to economists they have quite specific, and different, meanings. Economists, like a lot of academics, are quite arrogant. So when you use those two words interchangeably, they’re either confused or they conclude you’re ignorant and not worth taking seriously.

Income is what you earn during a period from wages, business profits or investments, plus cash benefits received from governments. Most income is spent on living expenses - consumption - while some is saved. Wealth, on the other hand, is the value of the assets you own, less any money you owe. You add to it by saving some of your income, by gifts and bequests from others and by capital gain. Income is measured over a period of time - a week or a year - whereas wealth is measured at a point in time, such as the first day or the last day of a week or a year. So income is a flow of value over time, whereas wealth is a stock of value at a point in time. Consumer spending is primarily done from income, but the two aren’t the same thing because people spend less than their income when they save, or more than their income when they borrow to finance additional consumption.

It’s clear that what we’re talking about in the wellbeing context is almost always income, not wealth or consumption. Another thing psychologists seem weak on is the distinction between absolute levels of income and relative income. Relative income is how much I earn during a period relative to what other people are earning. A person or household’s absolute level of income is viewed in isolation from other people’s, though it can be compared over time - with how much I earned a year ago or how much I expect to earn in a year’s time. This distinction may seem pedantic but, as we shall see, it’s pivotal to the interpretation of the effect of income on wellbeing.

Income and wellbeing

Let me summarise the research results as I understand them. The first point to make is that, contrary to popular wisdom, money does make us happy - up to a point. Studies of developing countries show that the higher the average level of income per person in a country, the happier the people in that country say they are. So, up to a certain point, rising GDP per person does make people happier. That point, however, is about $US10, 000 or $US15,000 a year per person - a point that Australia and all the other developed countries passed a very long time ago. Studies show that even though the people in rich countries' income per person has doubled or trebled in real terms since the 1950s, average levels self-reported happiness haven't changed - they haven't fallen, but nor have they risen. In other words, and to use an economists' term, when it comes to happiness, money is subject to significant DMU - diminishing marginal utility. An increase in our income adds little if anything to our utility.

Why do increases in absolute income do little to make us happier? Because of a pervasive human trait psychologists call adaptation. It doesn't take long before we get used to our newly improved circumstances and come to take them for granted. They get absorbed into the status quo and we go back to being about as happy as we always were. To put the point another way, soon after we achieve a higher level of material success, our aspirations move up another notch and we go back to being dissatisfied with our achievements.

The second point to make is that if, instead of comparing different countries over time, we look at particular countries at a point in time, we do find that people with higher incomes are happier than people with lower incomes. Particularly in the case of Australia, however, the difference is surprisingly small - that is, on average, rich people are only a bit happier than poorer people. How are these two seemingly contradictory findings reconciled? It's simple: people seem to be a lot more concerned about the level of their income relative to others than about what's happened to the level of their income over time. When all of us enjoy rising incomes at pretty much the same rate - which is what's been happening over the decades - none of us feels any better off. What little satisfaction we get from high incomes comes from having an income that's higher than other people's. We use our income as an indicator of success in life and of our social status. And some research suggests that it's really social status that affects our happiness much more than income as such.

Now, here’s where I beg to differ with my mate Bob Cummins (professor of psychology at Deakin University, Melbourne). When Bob looks at the results from the Australian Unity Wellbeing Index, and in his article in the Journal of Happiness Studies in 2000, he concludes that income has a significant effect on wellbeing. On average, people in the top income bracket report greater subjective wellbeing than those in the middle bracket and those in the middle report greater wellbeing than those in the bottom bracket. Well, I could quibble about whether those differences are big enough to be judged significant - to me they seem quite small. Very large increases in income are needed to produce quite modest increases in wellbeing - my point about income being subject to greatly diminishing marginal utility as income rises beyond the poor-country threshold.

Bob uses this evidence of greater levels of wellbeing for higher income-earners to argue that it supports the homeostatic theory of wellbeing - the theory that subjective wellbeing is held within a narrow range determined by personality. Bob argues that people with higher incomes enjoy higher wellbeing because they suffer less from homeostatic defeat. This is because they can buy the resources necessary to optimise the operation of their homeostatic system. Now, I want to make it clear that I’m not attacking the homeostatic theory as such. Indeed, I think we can drop the homeostatic bit out of the argument completely and we’re left with the standard materialist argument in favour of being rich: the rich are happier because they can afford to buy more than other people - more comfort, more assistance, more everything.

My point is that Bob hasn’t demonstrated, as he claims, that income has a significant effect on wellbeing. Rather he’s demonstrated a much smaller claim, that relative income has an effect on wellbeing. The point is that, if more income makes us happier because we can afford to buy more stuff (or, in Bob’s terms, because we can buy resources to overcome homeostatic failure) then, as everyone’s income rises over time in line with economic growth, all of us can afford to buy more stuff so our reported wellbeing should rise over time. But we know from many studies that though the real incomes of people in the developed economies have risen by a factor of three or four since World War II, their reported wellbeing hasn’t budged. So we’re left with the much more qualified statement that higher relative income increases the wellbeing of those towards the top. And we’re left with the likelihood that the reason a high-income earner feels a little happier has to do not with her ability to buy more stuff but with her knowledge that’s she’s been more socially successful than many others.

Why am I labouring this distinction between increasing absolute income over time and possessing a higher relative income at a point in time? Because it has profound implications for the goals of economic management. From the point of view of economists and politicians, this finding is bad news. Why? Because though the pursuit of economic growth can raise everyone's income in absolute terms, there's nothing it can do to raise everyone's relative income. Obviously, there'll always be some people who come towards the top of the class and some people who come towards the bottom. We might change the order around, but that will produce as many losers as winners, leaving the population no better off overall.

To repeat, this is a devastating conclusion for economists – and particularly economic rationalists – whose whole practical motivation has been based on the assumption that helping the community raise its productivity and increase its production and consumption of goods and services will leave it unequivocally better off. There is no doubt that, materially, we are better off than we were even 10 years ago: our homes are bigger and better, our cars are better, our food and clothing are fancier and we have any number of wonderful new gadgets to save us labour or entertain us. But though we are better off, we don’t feel better off.

Implications for economic policy

This brings us to the implications of wellbeing research for economic policy should economists and politicians someday incorporate them into their thinking. Richard Layard, a leading British economist who has embraced the psychological push says that, beside adequate income, the research shows six main factors affect happiness: mental health, satisfying and secure work, a secure and loving private life, a secure community, freedom, and moral values.

So my first policy implication is that reducing unemployment should be given a much higher priority by the economic policy-makers. Research shows that being unemployed makes people particularly unhappy, a lot more unhappy than can be explained by the loss of income they suffer by not having a job. What people miss is the sense of identity and self-worth that comes from a job, and also, no doubt, the social contact. Economists may protest that they are already giving high priority to reducing unemployment but, in truth, their pursuit of this goal is conditional. Their concern with the efficient allocation of resources means they frown on any solutions (job sharing, job-creation schemes, public sector employment, for instance) that involve modest inefficiencies. The truth is that the overwhelming goal of economists is to hasten the growth in the economy’s production of goods and services, and the jobs generated in this process are just a fortunate by-product.

My second policy implication is that governments and employers could do a lot to raise subjective well-being if they put more emphasis on the enrichment of jobs – increasing job satisfaction by giving workers more personal control, opportunity to use their skills, variety in tasks, respect and status, and contact with others. Taken literally, the economists’ model assumes that all work is unpleasant – a disutility – and is undertaken purely to gain the money to buy the things that bring utility. Like the rest of us, economists know that, in reality, work carries much intrinsic satisfaction. But they don’t follow this realisation through to their policy prescriptions. They are perpetually advocating labour market reform aimed at ensuring labour is used more efficiently, treating labour as though it were just another inanimate economic resource, and ignoring the feelings of the human beings attached to the labour. Various of the ways labour can be used more efficiently make life unpleasant and even unhealthy for the workers involved: ever-changing casual hours, rolling shift work, split shifts and firms continually moving their staff to different cities. When we pursue efficiency at the expense of people, economists have got things round the wrong way, trashing ends so as to advance means.

A third implication is that economic policy-makers should recognise the benefit of stability. People like stability – it makes them feel secure and happy. What’s more, it breeds a highly valuable commodity: trust. People don’t like continuous change. Macroeconomic management is aimed a stabilising the rate of growth in demand, and that’s good. But microeconomists perpetually advocate change (‘reform’) aimed at increasing efficiency, raising productivity and quickening the production of goods and services – the very objective we now know doesn’t make people any happier. Often, micro reform involves ‘displacing’ workers from the reformed industries where their labour wasn’t being used efficiently. This is a process that causes no heart searching among economists because their model: first, assumes alternative employment will be readily forthcoming; second, ignores the intrinsic satisfaction from work and, third, assumes unemployed workers will have a whale of a time enjoying all their new-found leisure.

A fourth policy implication is that the thing economists celebrate as ‘competition’ and are always trying to encourage because it acts as a spur to efficiency and growth, is actually ‘rivalry’ that creates losers as well as winners and thus generates roughly as much unhappiness as happiness. Rivalry is hardwired into our brains, but a case can be made that social comparison is not something we should be encouraging. Seen in this light, we should think twice about the unceasing calls for us to do this or do that to preserve or improve the economy’s international competitiveness. But why? It is just rivalry on a global scale. It is saying, we must make sure foreigners do not get richer at a faster rate than we are, or even, God forbid, overtake us on the league table.

Fifth, instead of merely unquestioningly promoting consumption, economists should be doing something they rarely do: studying it. They need to see whether there are some forms of consumption that that yield more satisfaction than others. It may be that, in our striving for social status, we are devoting too much of our time and income to the purchase of ‘positional goods’ - conspicuous consumption – and too little to activities empirical research now tells us would yield greater satisfaction. Robert Frank of Cornell says the ‘gains that endure’ are more likely to include social life, time with our children, less travel time to work, more job security and better health care. Layard says we should be spending a lot more on fighting glaring evils – and sources of profound unhappiness - such as depression.

Sixth, the evidence that income is subject to diminishing marginal utility strengthens the case for redistributing income from rich to poor, since such transfers should increase total happiness. As yet, however, there is mixed evidence on the question of whether people who live in countries with a narrower gap between rich and poor are happier. Alesina et al. (2001) find that income inequality has a large negative effect on happiness in Europe, but not in the United States.

Finally, we should look sceptically at the incessant calls for lower tax rates to encourage people to work harder. By its very nature, the economists’ model assumes away all non-monetary motives for work. We do it only for the money. But the reminder of the intrinsic satisfaction we derive from work also reminds that higher income-earners in particular have powerful non-monetary motives for working long and hard: job satisfaction and the pursuit of power and status. Reducing tax rates would merely allow us to run faster on the hedonic treadmill, whereas I think we should slowdown. The drive for reduced government spending and lower taxes would leave people with more disposable income they could use to purchase education and health care privately, in the hope that these positional goods would enhance their social standing. Layard warns we should worry lest leisure, public goods and inconspicuous consumption (consumption that is not compared with the consumption of others) are under-produced because people focus so much on conspicuous consumption.