Wealth, Worth, and Well-Being: A Behavioral Economics Perspective
What if the key to happiness isn’t how much we earn, but how we think about spending? Behavioral economics offers insights into why our perceptions of income and consumption often defy traditional logic—and how these insights can reshape public policies to boost societal well-being.
By examining the psychological and social factors that shape our relationship with money, we can better understand the complex link between income, happiness, and the potential role of public policy in enhancing societal well-being.
Happiness is generally understood as a subjective, emotional state that reflects an individual's momentary feelings or overall life satisfaction. Economists typically measure happiness through subjective well-being (SWB) surveys, where individuals self-report their level of happiness or satisfaction with life. These surveys often ask people to rate their happiness on a scale, considering their emotional experiences over a given period or their life as a whole (Stutzer & Frey, 2012). In behavioral economics, happiness is often influenced by hedonic factors, such as moment-to-moment pleasures or positive emotions associated with experiences (Kahneman & Deaton, 2010).
By contrast, well-being encompasses a broader concept that includes not only emotional satisfaction but also factors related to a person’s overall quality of life and flourishing. Well-being is often broken into different dimensions, such as economic well-being (financial security, income stability), physical well-being (health, safety), mental and emotional well-being (life satisfaction, sense of purpose), and social well-being (relationships, community support).
Economists measure well-being through a mix of objective indicators (ex., income levels, health statistics, education, employment rates) and subjective well-being measures, much like those used to gauge happiness. Well-being also factors in eudaimonic elements, which focus on meaning and purpose in life, rather than simply momentary pleasure or satisfaction. For example, higher well-being might come from feeling purposeful in one’s job, having good relationships, or maintaining health, which are not always captured by income metrics alone (Nikolova & Graham, 2020).
It is essential to differentiate between the immediate emotional responses associated with happiness and the broader, more complex factors that contribute to overall well-being. This distinction helps to distinguish how income, spending habits, and public policy shape both short-term happiness and long-term well-being.
How does behavioral economics help explain the relationship between income, consumption, and well-being?
Income undoubtedly affects a person's happiness, but its impact is far from straightforward. Numerous studies and literature have found that changes in income may have a strong immediate impact on a person's state of being, both positively or negatively. However, the longer-term reaction from the individual is subjective. An individual can be positively impacted by their level of income up to a certain point, and beyond that point, the correlation between income and happiness decreases.
Take the case of someone named Sarah, who was initially earning $40,000 per year. When she received a raise to $70,000, she felt a significant boost in happiness. With the additional income, she could afford a nicer apartment, go on vacations, and save for the future—improvements that had a tangible impact on her well-being. However, when Sarah's salary increased again to $100,000, she noticed that while she enjoyed the financial security, the additional income didn’t bring the same level of excitement or happiness as before. Her basic needs were already met, and while she could spend more on luxury items, her day-to-day contentment plateaued.
Sarah’s example aligns with research suggesting that while income increases can enhance happiness, the effect tapers off once basic needs and comfort are secured. Sarah’s happiness peaked at a certain income level, after which further financial gains no longer contributed as much to her overall well-being.
Sarah’s diminishing marginal utility is why behavioral economics is important to study, due to the fine connection between decision making related to income. Behavioral economics provides a nuanced understanding of the relationship between income, consumption, and well-being by highlighting the significance of both subjective experiences and social comparisons that shape individuals' life satisfaction.
While higher income is generally associated with greater life satisfaction and typically has a positive effect on people, the correlation is not as straightforward as it may seem. For instance, it is well noted that “subjective well-being reflects the notion that how people experience a set of circumstances is as important as the circumstances themselves, and that people are the best judges of how their own lives are going” (Nikolova & Graham, 2020). Their perspective highlights the importance of considering individuals' perceptions and experiences rather than solely their income levels. However, they also note, “It is widely accepted in the literature that in a cross-section, rich individuals within a country have higher positive hedonic well-being and life satisfaction levels than their poorer compatriots.” Kahneman and Deaton (2010) found that while money does make people happier, up to a salary of around $75,000 a year; beyond that, more income doesn’t necessarily lead to greater day-to-day happiness. However, when it comes to how people evaluate their overall life satisfaction, income continues to make a difference, with no clear point where the effect levels off, at least in the short term.
Additionally, behavioral economics explains how adaptation and relative income influence the relationship between income and well-being. Studies have shown that “adaptation to income and other aspects of economic and social life is incomplete, meaning that while individuals may recover from economic shocks, their life satisfaction does not necessarily return to its previous levels (Nikolova & Graham, 2020). A change in income level may have a temporary effect on the individual’s well-being. Still, it may not completely take control over their entire well-being because hedonic well-being is made up of many factors. This is in part caused by the phenomenon of habituation, where individuals become accustomed to their income levels, so any immediate change in income has the potential to affect someone’s well-being in the short term but limits the long-term impact of income on happiness. Levinson notes, “self-reported happiness does not increase with income across countries or within a country overtime, but it does increase with income (across individuals within a country at any given time)” (2013). This finding suggests that income increases happiness in relative terms but not in absolute terms over time. This finding further reinforces the view that happiness is a subjective metric and cannot be used reliably for generalizations.
Likewise, the negative effect of average earnings on self-reported happiness reinforces the role of social comparisons and the aspiration-based nature of happiness, according to Stutzer and Frey (2012). These insights illustrate that while income influences well-being, it is mediated by psychological and social factors that make the relationship more complex and multifaceted.
All things considered, income can boost happiness to a certain extent and it’s clear that factors like social comparisons, adaptation, and personal experiences play a significant role in shaping overall well-being. This understanding pushes policymakers to think beyond simple economic growth and consider the complex psychological and social dynamics that influence happiness.
What are the implications of behavioral economics for public policy aimed at increasing societal happiness and well-being?
Some might say that public policy is the driving influence behind collective welfare. The integration of behavioral economics into public policy offers insights into how societal happiness and health can be enhanced. By considering subjective well-being alongside traditional economic indicators, policymakers can better assess the full impact of their interventions.
The integration of behavioral economics into public policy has significant implications for enhancing societal happiness and well-being. One of the key contributions of behavioral economics is its support for a broadened approach to welfare measurement. Traditional economic indicators, such as GDP, often fail to capture the full spectrum of human well-being. By incorporating subjective well-being measures into policy analysis, policymakers can develop a more sophisticated understanding of welfare, as advocated by the Stiglitz-Sen-Fitoussi Commission and the OECD Better Life Initiative. This multidimensional approach would allow for a comprehensive evaluation of how policies impact various aspects of life, such as health, education, and environmental quality. By assessing these broader indicators, policymakers can better balance the consequences of interventions and ensure that improvements in one area do not lead to unintended negative outcomes in another.
Nikolova and Graham suggest that "Policymakers can be helped by translating well-being metrics into terms that can be fed into cost-benefit and cost-effectiveness equations... They may want to put a monetary value on different experiences and life events” (2020). Evidence from subjective well-being research reveals that the perceived benefits or costs to individuals may significantly deviate from what traditional economic models or market prices indicate. In fact, the gains in well-being resulting from increased income tend to be more substantial for individuals with lower incomes compared to wealthier counterparts. As cost-benefit analyses frequently use monetary metrics, weighing the benefits and costs to reflect these disparities allows for more equitable assessments, especially when considering the disproportionate value that incremental income holds for lower-income households.
If we consider happiness as a stand-in for utility, it becomes possible to quantify the gradient of an indifference curve. By framing policymakers as maximizing happiness rather than utility, it would be reconceptualized as an "iso-happiness" curve. This redefinition may allow us to utilize surveyed happiness data to assess the value of public goods. Behavioral economists create non-standard utility functions to better model and explain seemingly irrational human behavior. Happiness economists, on the other hand, use self-reported happiness as a proxy for traditional utility concepts. Both approaches integrate psychological insights into economic theory, challenging the conventional assumption that people always make decisions to maximize a well-defined utility. These methods offer alternative ways to address the limitations of neoclassical economics, with significant implications for public policy. Behavioral economists have developed interventions based on irrational behaviors, while happiness measures help quantify policy outcomes that are more difficult to value, such as the emotional costs of unemployment and pollution.
Most traditional economic models fail to quantify the true impact of policies on human happiness and prosperity, especially in cases where market prices do not reflect social values such as healthcare or environmental sustainability. Policymakers can more accurately assess the value of public goods and services by translating well-being metrics into monetary terms, which further enhance policy decisions to be more informed and effective. While these approaches offer valuable insights, they come with some challenges. For instance, there is ongoing debate about the legitimacy of using happiness as a sole measure for public policy, given the behavioral biases – habituation and projection bias – that can distort the relationship between income, consumption, and well-being. So, while subjective well-being measures provide essential inputs in the democratic policy process, they should be used cautiously and in conjunction with other indicators that guide policy. "A measure of social welfare based on happiness data is democratic in the sense of attributing equal weight to every person." (Stutzer & Frey, 2012).
Furthermore, Stutzer & Frey (2012) also argue that happiness policy should be grounded in public choice theory, cautioning against a centralized approach that maximizes aggregate happiness, as it resembles a "benevolent dictator" model. Instead, they advocate for a constitutional framework where subjective well-being is evaluated through a comparative analysis of institutions. They assert that the legitimacy of political actions relies on voluntary citizen consent, emphasizing that individual sovereignty extends beyond self-reports of happiness. Happiness research should inform the democratic process but must still be scrutinized through public discourse and political competition.
By incorporating subjective well-being into policy design, governments would be capable of adopting a more holistic approach to measuring prosperity, one that goes beyond traditional economic indicators like GDP. This approach would allow for the evaluation of policy outcomes based on how they impact various dimensions of life, which could ultimately lead to more effective decision-making processes. However, as Frey and Stutzer cautioned, happiness measures should be carefully integrated into the democratic process, ensuring they are balanced with other indicators and engage in robust public discourse and examination, as every other policy measure is.
Works Cited
Levinson, N. (2013). Happiness, Behavioral Economics, and Public Policy. Working Paper 19329, National Bureau of Economic Research. https://www.nber.org/papers/w19329
Kahneman D, Deaton A. High income improves evaluation of life but not emotional well-being. Proc Natl Acad Sci USA. 2010 Sep 21;107(38):16489-93. doi: 10.1073/pnas.1011492107
Nikolova, M. & Graham, C. (2020). The Economics of Happiness. GLO Discussion Paper, No. 640, Global Labor Organization (GLO), Essen. https://www.econstor.eu/bitstream/10419/223227/1/GLO-DP-0640.pdf
Stutzer, A. & Frey, B. (2012). Recent Developments in the Economics of Happiness: A Selective Overview. IZA Discussion Paper No. 7078, The Institute for the Study of Labor (IZA). https://docs.iza.org/dp7078.pdf
