Reference Groups, Reference Income and Inequality Perception

The Easterlin paradox questions the way income can enter a utility function. Individuals are said to be sensitive not to the level of their income, but to their relative income as measured by the ratio between their income and the mean income of their reference group. We propose a reference group based on human capital and relate well-being to income dynamics using panel data with income variations, permanent income and reference income using the six last waves of the BHPS. Considering the sole reference income is not enough to fully model the influence of the reference group. Inequality within subgroups has to be introduced in order to obtain a correctly specified model. Individuals consider within-group inequality as an opportunity, a reward of their efforts and talents. Inequality as a risk can be identified, using another reference group, chosen to be orthogonal to the first one.