Positional Externalities Cause Large and Preventable Welfare Losses

Abstract

In traditional economic models, individual utility depends only on absolute consumption. These models lie at the heart of claims that pursuit of individual self-interest promotes aggregate welfare. Recent years have seen renewed interest in economic models in which individual utility depends not only on absolute consumption, but also on relative consumption. In contrast to traditional models, these models identify a fundamental conflict between individual and social welfare. The conflict stems from the fact that concerns about relative consumption are stronger in some domains than in others. The disparity gives rise to expenditure arms races focused on positional goods—those for which relative position matters most. The result is to divert resources from nonpositional goods, causing welfare losses. Compelling theoretical and empirical evidence confirms the importance of relative consumption in individual valuations. In light of this evidence, we must question the wisdom of economic policy recommendations stemming from models that ignore relative consumption.