Does Income Inequality Cause Higher Housing Prices?

Basic microeconomic theory is incomplete in its description of consumption and utility if status influences individual utility. In equilibrium the amount of consumption spent on positional goods such as housing will be larger than what is socially optimal. This equilibrium over-consumption is called a consumption externality and results in a Pareto inferior equilibrium. A rise in consumption of housing by the top earners will influence housing consumption throughout the entire economy if consumption externalities exist. Data on Danish municipalities during the period from 1995 to 2002 is analyzed in order to test this hypothesis empirically. A strong positive correlation between income inequality and housing prices is found. This is evidence in favour of the existence of consumption externalities.