A Formal Economic Theory for Happiness Studies: A Solution to the Happiness-Income Puzzle∗

This paper develops a formal economic theory that is mainly proposed to explain and study the Easterlin paradox — a puzzle at the heart of our lives: average happiness levels do not increase as countries grow wealthier. This theory provides a foundation for studying happiness from the perspectives of social happiness maximization and pursuing individual self-interest. It takes into account both material goods and non-material goods, integrates the existing reference group theory and the “omitted variables” theory, and identifies a fundamental conflict between individual and social welfare/happiness. We show that, up to a critical income level that is positively related to non-material status, increase in income enhances happiness. Once the critical income level is achieved, increase in income cannot increase average happiness and in fact, somewhat surprising, average happiness actually decreases, resulting in Pareto inefficient outcomes. A policy implication of our theory is that government should promote material and non-material goods in a balanced way. Our empirical analysis confirms the implication and shows that the results are robust across the countries under consideration.