The Role of Peer Effects on Households Consumption and Finance

peer effects

Peer Effects on Households Consumption

The basic idea of peer income’s influence on households’ consumption was first constructed by Duesenberry (1949) in his book about relative income hypothesis. According to this theory, households with below average income do not have the incentives to keep more savings. Instead, they tend to spend a larger proportion of their budgets in consuming, especially extremely visible goods, to match up with their peers.

Kuhn and co-authors (2011) study the social impact of income shock from winning a lottery on the winners themselves and their neighbors who live next door. To be specific, they gather information from the Dutch Postcode Lottery which consist of information on participants and non-participants in both winning and non-winning postcodes with special focus on these groups’ level of happiness and consumption. By winning the weekly Street Prize, one random household would get a new BMW in addition to an amount of 12,500 euro for every winning one. This amount is approximately eight months of an average household’ income and thus considered an income shock to the winning household. The public advertising for these weekly awards is so intense and appealing that the number of participants amounts up to a quarter of Dutch population. After some research, they find out that non-participating households in the winning areas are significantly more likely to purchase a new car not long after the lottery. Specifically, households living in close proximity with the lottery winners increase their probabilities of purchasing a new car within half a year by 7 percentage points. On the other hands, they also decrease the mean age of their current cars by approximately 7 percent which is equivalent to a period of six months. Among all consuming goods, cars are expected to be the most visible products since households constantly remind their neighbors about these new purchases by driving them. These results are encouraging the theory of “keep up with the van den Bergs” to explain increased consumption of households under social effects even though there might as well be other alternative explanations such as next-door neighbors buying back the BMWs from winning households. Another research of peer effect on households’ consumption is Charles et al. (2009) which reports status concerns as a reason for minority races’ huge amount of spending on visible goods such as cars, jewelry, exterior home renovations, etc. in the United States.

Overall, with these empirical evidence, there seem to be some significant correlation between peer income and households’ increase in consumption. The main question regarding this matter is how these households finance their substantial consumption, especially when households who perceived themselves as poorer than their social circles are actually consuming more to catch up.

Peer Effects on Households Finance

Recently, Georgarakos et al. (2014) provide some robust evidence for peer income effects on households’ increase in debts. To be specific, they first ask households to give some estimates on the income of their close friends, relatives and colleagues, etc. in order to construct a variable of perceived peer income. After that, they try to study the marginal effect of this variable on four categories including the probabilities of households obtaining a loan or increasing their outstanding loans with regards to both collateralized and non-collateralized (or consumer) loan types. As expected, perceived peer income show statistically significant correlation with households’ financing decisions. Specifically, households’ perceptions about their acquaintances’ income contribute approximately 10% and 7% respectively to the probability of them taking out new collateralized and consumer loans. In case of households with outstanding amount of debts, they might increase this amount by 15,000 and 400 euro respectively.

This finding might be tempting as a possible explanation for the big question raised at the end of the first part. In order to finance their considerably substantial increase in consumption to catch up with their peers, households tend to seek out for more collateralized and consumer loans. Georgarakos et at. (2014) also detect positive and statistically significant results for the influence of peers’ consumption standards on households’ borrowing decisions without weakening the above mentioned effects of peer income. These findings strongly support the hypothesis that households finance is somehow influenced by the social comparison effect. Even though it does not imply that households have intentions of defaulting on these loans, many of them find themselves in financial distress due to these financing decisions.

From Peer Effects to Households Financial Distress

As mentioned above, the positive results for peer effects on households’ borrowing do not imply any intentionally illegal or dishonest behaviors from them. However, estimation of peer income effects on households’ potential financial distress claims that an increase of 12,000 euro in households’ perceptions about acquaintances’ annual income would contribute 1.2 and 0.3 percentage points to an average loan-to-value ratio and debt-service ratio of 18% and 6% respectively. These findings suggest that households are more likely to experience financial distress afterwards under the influence of peer effects. On the other hand, these social effects surprisingly influence poorer households more. Even though it is difficult for them to obtain loans due to low credibility, recent studies show that credit standards usually loosen up prior to financial crisis. Indeed, Demyanyk and Van Hemert (2012) prove that six consecutive years before the crisis, loan quality dramatically deteriorated while the average combined loan-to-value ratio increased regardless of credit providers’ awareness. In addition, Christelis et al. (2013) find robust evidence of households prior to the crisis in the United States holding higher amounts of mortgage than those in European countries with the same characteristics and income.

Therefore, studies of peer effects on households’ finance might shed some lights on how legislators should take precautions against these negative signals. Additionally, they should take into account the impact of social effects when they design some aid programs or tax policies for instance.

References

  1. Georgarakos, D., M. Haliassos, G. Pasini. 2014. Household debt and social interactions. Review of Financial Studies, doi:10.1093/rfs/hhu014: pp. 1-30
  2. Kuhn, P., P. Kooreman, A. Soetevent, and A. Kapteyn. 2011. The effects of lottery prizes on winners and their neighbors: Evidence from the Dutch Postcode Lottery. American Economic Review 101: pp. 1-30
  3. Christelis, D., D. Georgarakos, and M. Haliassos. 2013. Differences in portfolios across countries: Economic environment versus household characteristics. Review of Economics and Statistics 95: pp. 1-6
  4. Demyanyk, Y., and O. Van Hemert. 2012. Understanding the subprime mortgage crisis. Review of Financial Studies 24: pp. 1-3
  5. Duesenberry, J. 1949. Income, saving and the theory of consumer behavior. Cambridge, MA: Harvard University Press
  6. Charles, K., E. Hurst, and N. Roussanov. 2009. Conspicuous Consumption and Race. Quarterly Journal of Economics 124: pp. 1-5.

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