Inequality aversion and externalities

We conduct a general analysis of the effects of inequality aversion on decisions by homogeneous players in static and dynamic games. We distinguish between direct and indirect effects of inequality aversion. Direct effects are present when a player changes his action to affect disutility caused by inequality. Indirect effects occur when the own action is changed to affect other players’ actions. We provide necessary and sufficient conditions for the occurrence of either effect. Moreover, we examine the direction of the effects. Whereas indirect effects induce players to internalize externalities they impose on others, direct effects act in the opposite direction.

► We conduct a general analysis of the effects of inequality aversion on players’ actions.
► We distinguish between direct and indirect effects of inequality aversion.
► We provide necessary and sufficient conditions for the occurrence of either effect.
► Externalities are necessary for inequality aversion to affect behavior.
► Direct and indirect effects are found to always act in opposite directions.