Will the Consumption Externalities' Effects in the Ramsey Model Please Stand Up?

Abstract

This paper investigates household decisions when individual utility depends on a consumption reference level. The desire to “keep up with the Joneses'' represents one such example. The prior literature shows that, in a Ramsey model, consumption externalities have no impact on steady state behavior, once labor supply is exogenous. In contrast, this paper argues that – once there is (exogenous) technological change – consumption externalities always affect steady state behavior, even if labor supply is exogenous. The nature of the effects depends on the consumption externality's impact on a household's elasticity of marginal utility of consumption.

Keywords: Consumption externality, keeping up with the Joneses, Ramsey model, intertemporal elasticity of substitution

JEL Classification: D91, E21, O41