Relative income concerns and the Easterlin Paradox: A theoretical framework

This paper analyzes the relationship between relative income concerns and individual well-being in an economy of heterogeneous firm-worker pairs characterized by moral hazard with respect to the worker’s effort. At the individual level, we use the standard principal-agent paradigm to study the design of incentive contracts when workers compare their earnings with the economy’s average wage. At the aggregate level, we define the economy’s equilibrium and prove that it always exists. We then analyze the impact of technological improvements and identify various channels through which economy-wide income growth can negatively affect an individual’s well-being. We show that in many cases, an increase in average earnings generates the Easterlin Paradox, whereby average expected utility for workers is stagnant or even reduced. We discuss empirical predictions resulting from our model and suggest how our analysis can help evaluate the effects of various policy interventions.