Context externalities

by Rob Horning

1 May 2007


In the course of an argument about income and substitution effects between economists Greg Mankiw and Robert Frank playing out on Mankiw’s blog, Frank raises the notion of context externalities, which I thought was a helpful way of reframing the question I keep coming back to of whether there’s a route to a more direct (a.k.a. “authentic”) experience of consumption, and if that route is even desirable.

As decades of behavioral evidence clearly demonstrates, virtually every evaluation is heavily shaped by local context. As Richard Layard put it, “In a poor society a man proves to his wife that he loves her by giving her a rose, but in a rich society he must give a dozen roses.” Because evaluation drives consumer choice, context is an important determinant of consumer demand. The upshot is that almost every consumer choice generates significant context externalities.
Consider, for example, a job applicant’s decision about how much to spend on an interview suit. His goal is to make a favorable impression. But his ability to do so depends far less on the absolute quality of his suit than on how it compares with those worn by other applicants. And when he spends more on a suit, he shifts the context within which other candidates will be evaluated.

Context externalities are pervasive. A good school, for instance, is one that compares favorably with other schools in the same local environment. The amount parents must spend to ensure that their children attend such a school is thus an increasing function of the amounts spent by other parents. The evaluations that guide an employer’s promotion decisions are similarly dependent on context. A worker’s odds of promotion depend less on his absolute performance than on how well he performs relative to his coworkers.

The dependence of evaluation on context lays waste to any presumption that individual decisions about how many hours to work or how much to spend on interview suits will be socially optimal. The general result predicted by theory is that if context shapes evaluation more heavily in some domains than others, too many resources will flow to the most context-sensitive domains and too few to the least context-sensitive domains.

I put in bold the sentence that started me thinking about whether there is anyway to disrupt that evaluation process and thereby restore a sense of agency to the individual (one’s consumerism would no longer be a matter beyond one’s personal control) while snuffing out these externalities. Those with an undying faith in the sovereignty of the individual might argue that a force of will is sufficient to put an end to such evaluation, that personal weakness is what drives invidious comparison. This has the ring of common sense (“What do you care what anyone else thinks? Why are you so insecure?”), but the fact that it seems like common sense should be enough to make us wonder how ideologically driven the reaction is.

Anyway I need to read further to see what solutions have been devised to control these externalities, and whether or not they are battling human nature itself.

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