choice, which holds that utility depends on the absolute amount of consumption, the uniquely correct choice is World A. For if absolute house size is all that matters, A is indeed a better world for all, since everyone has a larger house there than the largest house in World B. The important thing, though, is to focus on how you would feel in the two worlds.
In fact, most people say they would pick B, where their absolute house size is smaller but their relative house size is larger. Even those who say they would pick A seem to recognize why someone might be more satisfied with a 3,000-square-foot house in B than with a substantially larger house in A. If that is true for you as well, then you accept the main premise required for the arguments I will present.
In the second thought experiment, your choice is between World C, in which you would have four weeks a year of vacation time and others would have six weeks; and World D, in which you would have two weeks of vacation and others one week. This time most people pick C, choosing greater absolute vacation time at the expense of lower relative vacation time.
I use the term positional good to denote goods for which the link between context and evaluation is strongest and the term nonpositional good to denote those for which this link is weakest.1 In terms of the two thought experiments, housing is thus a positional good, vacation time a nonpositional good. The point is not that absolute house size and relative vacation time are of no concern. Rather, it is that positional concerns weigh more heavily in the first domain than in the second.
The argument I will advance in this book can be reduced to four simple propositions.
1 People care about relative consumption more in some domains than in others. Or, to put this proposition in more neutral language, context matters more in some domains than in others. The two thought experiments just discussed illustrate this proposition. Although context matters for evaluations of both housing and leisure time, it matters more for evaluations of housing.
2 Concerns about relative consumption lead to “positional arms races,” or expenditure arms races focused on positional goods. In the context of the two thought experiments, this proposition says that individuals will work longer hours to earn the money that will enable them to buy larger houses, expecting to enjoy the additional satisfaction inherent in owning a relatively large house.
3 Positional arms races divert resources from nonpositional goods, causing large welfare losses. When people contemplate working longer hours to buy larger houses, they anticipate additional satisfaction not only from having a larger house in absolute terms, but also from having a larger house in relative terms. For the move to appear attractive, the anticipated sum of these two gains must outweigh the loss in satisfaction associated with having fewer hours of leisure. When all make the same move in tandem, however, the distribution of relative house size remains essentially as before. So no one experiences the anticipated increase in relative house size. When the dust settles, people discover that the gain in absolute house size alone was insufficient to compensate for the leisure that had to be sacrificed to get it. Yet failure to buy a larger house when others do is not an attractive option for the individual, either. As in the familiar stadium metaphor, all stand to get a better view, but when all stand no one sees better than when all were seated.Because proposition 3 contradicts standard assertions about efficient resource allocation in competitive markets, the impulse of many economists will be to reject it. Yet its logic is precisely the same as the logic that governs the analogous, and completely uncontroversial, claim regarding military arms races. People in every nation want both a high material standard of living and protection from aggression from other nations. To protect against aggression, resources must be diverted from other forms of consumption into military armaments. Relative expenditures clearly matter more in the armaments domain than in the consumption domain. After all, a nation that spends less than its rivals on armaments puts its political independence at risk, whereas one that spends less than its rivals on consumption risks only a reduction in relative living standards. In short, military arms races result because most people believe that being less well armed than one’s rivals is more costly than having fewer flat-panel television sets. By the same token, positional arms races result because consumption evaluations are more sensitive to context in some domains than in others.
4 For middle-class families, the losses from positional arms races have been made worse by rising inequality. As I will presently discuss, most of the income gains in the United States during the past several decades have gone to people at the top of the income distribution. Not surprisingly, their higher incomes have led these people to build larger houses. There is little evidence that middle-class families envy the good fortune of the wealthy. Yet through a chain of indirect effects I will describe, the larger houses at the top have led families in the middle to spend sharply higher fractions of their incomes on housing, in the process forcing them to curtail other important categories of spending.
Our task in the pages ahead will be to examine these propositions in greater detail. But before taking up the question of whether rising inequality harms the middle class, I will first examine the extent to which inequalities in income and wealth have, in fact, been rising.
CHAPTER TWO
Recent Changes in Income and Wealth Inequality
Presidential aspirants since Ronald Reagan have urged us to ask whether we’re better off now than we were four years ago. At any time from 1945 to the early 1970s, the answer for most Americans would have been a resounding yes. Throughout that period, incomes grew at about 3 percent a year for families up and down the income ladder.
Today, however, this question is more difficult to answer. During the past several decades, the distributions of income and wealth in the United States have changed in such a way that the economic environment for most upper-middle-class people has become much more like that of World A than of World B in our earlier thought experiment. For example, although the top 1 percent of earners now have more than three times as much purchasing power as in 1979, the real earnings of families in the middle have risen only slightly since then. The meager income growth that these families have experienced has come not from hourly wage increases, but rather from growth in the labor force participation of married women.
The conventional wisdom has long been that a growing gap between the rich and the middle class is a bad thing. But that view is now under challenge. Some revisionists, respected economists among them, argue that inequality doesn’t really matter so long as no one ends up with less in absolute terms. Using income levels to measure the well-being of individual families, these inequality optimists argue that since the rich now have much more money than before and the middle class doesn’t have less, society as a whole must be better off.
Yet “having more income” and “being better off” do not have exactly the same meaning. I will argue that changes in spending patterns prompted by recent changes in the distributions of income and wealth have imposed not only important psychological costs on middle-income families but also a variety of more tangible economic costs.
I begin with a brief look at the changes that have occurred in the distributions of income and wealth in the United States during the decades following World War II. Income growth from 1949 until the end of 1970s was well depicted by the famous picket-fence chart shown in figure 1. Incomes grew at about the same rate for all income classes during that period, a little less than 3 percent per year. It varied a bit across income classes, but no matter where you fell along the income scale, you enjoyed fairly robust income growth.
Since consumption expenditures tend to track incomes closely, spending was also increasing at a fairly uniform rate across the income scale during this period. The houses in which rich people lived in 1979 were bigger than those of their counterparts in 1949, but the same was also true, and by roughly the same proportion, of the houses in which poor and middle-income people lived. In short, income and consumption growth were balanced across income categories during the three decades following World War II.
