Happiness Inertia: Analytical Aspects of the Easterlin Paradox

Using a New-Keynesian flexi-price model with external habit formation in consumption and labor supply, we identify the channels underlying the Easterlin Paradox (or “Happiness Inertia”, its generalization). These include whether external habit formation is in “difference” or “ratio” form; the growth and convexity characteristics of non-pecuniary effects; and the nature of risk aversion. We show that the impact of labor habit formation on welfare can (unlike consumption) be positive or negative. The form of habit formation (rather than habit per se) is a key determinant of whether welfare functions reproduce happiness inertia; only when habit is modelled in ratio form, does this possibility open up. The model thus bridges the gap between theoretical models and social policy, pecuniary and non-pecuniary motives.