Adaptation, anticipation and social interaction in happiness: An integrated error-correction approach

• I estimate adaptation, anticipation and social-reference effects on life satisfaction.
• I focus on short and long-run effects of income and social reference income.
• GMM estimates for instrumented income variables reveal significant adaptation to income.
• Social reference income has a strongly negative long-run impact.
• My estimates imply a more comprehensive explanation of the Easterlin paradox.

Adaptation, anticipation and social-reference effects on happiness are strongly interrelated phenomena. However, in the existing empirical literature these phenomena are mainly studied in isolation from each other. Therefore, using SOEP panel data for the years 1984–2007, this study offers an integrated investigation of the implications of these three phenomena for the dynamics of individual life satisfaction. I focus on the short and long-run effects of income and social reference income, but I control for similar dynamics with respect to a large set of control variables. GMM estimates for instrumented income variables in an error-correction model indicate an insignificant future income effect, a significant and positive current income effect, and an insignificant long-run income effect on life satisfaction with significant hedonic adaptation. Social reference income has a significant, negative and strong impact in the long run, but not in the short run. Consequently, increasing own income and reference income by the same percentage tends to have an insignificant effect in the long term, but a significant and positive effect in the short term. Adaptation to an income shock and reinforcement of a reference income shock take place for more than 90% within three years. On the basis of these results a more comprehensive explanation of the Easterlin Paradox than those given in the literature is presented.