We apply an optimizing model with relative comparisons (habit formation) in consumption and labour supply to the economics of happiness, specifically the ‘Easterlin paradox’. Studying a generalization of the paradox, which we label the ‘happiness puzzle’, we analyse ways in which income growth affects happiness. In our model, those factors include agents' risk aversion; whether the economy experiences balanced or unbalanced growth; how non-pecuniary factors affect well-being; and the degree of market imperfections. We also demonstrate that the dynamic specification of habit formation rather than its mere existence matters for whether the happiness puzzle arises on a balanced growth path. Only when habit is modelled in ratio form, does this possibility open up. Our model thus bridges the gap between theory, empirics and social policy. It provides a basis for studying a number of specific policy issues, such as corrective taxes.
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