Relative Income Hypothesis

The Relative Income Hypothesis The relative income hypothesis of James Duesenberry is based on the rejection of the two fundamental assumptions of the consumption theory of Keynes. Duesenberry states that:

(1) every individual’s consumption behaviour is not independent interdependent of the behaviour of every other individual, and (2) that consumption relations are irreversible and not reversible in In formulating his theory of the consumption function, Duesenberry time.

2. No Direct Relation between Consumption and Income: This hypothesis assumes the relation between consumption and income to be direct. But this has not been borne out by experience. Recessions do not always lead to decline in consumption, as was the case during the recessions of 1948-49 and 1974-75

3. Distribution of Income not Unchanged: This theory is based on the assumption that the distribution of income remains almost unchanged with the change in the aggregate level of income. If with increases in income, redistribution occurs towards greater equality, the APC of all persons belonging to the relatively poor and relatively rich families will tend to be reduced. Thus the consumption function will not shift upward from C to C when income increases

4. Reversible Consumer Behaviour: According to Micheal Evants, “The consumer behaviour is slowly reversible over time, instead of being truly irreversible. Then previous peak income would have less effect on current consumption, the greater the elapsed time from the last peak” Esen if we know how a consumer spent his previous peak income, it is not possible to know how he would spend it now

5. Neglects Other Factors: This hypothesis is based on the assumption that changes in consumer’s expenditure are related to his previous peak income. The theory is weak in that it neglects other factors that influence consumer spending such as asset holdings, urbanisation, changes in age composition, the appearance of new consumer good, etc.

6. Consumer Preferences do not depend on others: Another unrealistic assumption of the theory is that consumer preferences are interdependent. whereby a consumer’s expenditure is related to the consumption patterns of his rich neighbour. But this may not always be true.

George Katona’s empirical study has revealed that expectations and attitudes play an important role in consumer spending According to him. income expectations based on levels of aspirations and the attitudes toward asset holding affect consumer spending behaviour more than the demonstration effect.

7. Reverse Lighting Both Effect: Smith and Jackson have criticised Duesenbery’s empirical evidence that the recovery in income after recession is not caused by ratchet effect. Rather, the consumption experience of consumer is similar to the reverse lighting bolt effect.

writes: “A real understanding of the problem of consumer behavior must begin with a full recognition of the social character of consumption patterns.”

By the “social character of consumption patterns” he means the tendency in human beings not only “to keep up with the Joneses” but also to surpass the Joneses. Joneses refers to rich neighbours.

In other words, the tendency is to strive constantly toward a higher consumption level and to emulate the consumption patterns of one’s rich neighbours and associates. Thus consumers’ preferences are interdependent. It is, however, differences in relative incomes that determines the consumption expenditures in a community.

A rich person will have a lower APC because he will need a smaller portion of his income to maintain his consumption pattern. On the other hand, a relatively poor man will have a higher APC because he tries to keep up with the consumption standards of his neighbours or associates.

This provides the explanation of the constancy of the long-run APC because lower and higher APCs would balance out in the aggregate. Thus even if the absolute size of income in a country increases, the APC for the economy as a whole at the higher absolute level of income would be constant. But when income decreases, consumption does not fall in the same proportion because of the Ratchet Effect.

The Ratchet Effect:

The second part of the Duesenberry theory is the “past peak of income” hypothesis which explains the short-run fluctuations in the consumption function and refutes the Keynesian assumption that consumption relations are reversible.

The hypothesis states that during a period of prosperity, consumption will increase and gradually adjust itself to a higher level. Once people reach a particular peak income level and become accustomed to this standard of living, they are not prepared to reduce their consumption pattern during a recession.

As income falls, consumption declines but proportionately less than the decrease in income because the consumer dissaves to sustain consumption. On the other hand, when incor increases during the recovery period, consumption rises gradually with a rapid increase in saving. Economists call this the Ratchet Effect.

Duesenberry combines his two related hypothesis in the following

C/Y,-a-cY/Y

form:

Where C and Y are consumption and income respectively. t refers to the current period and the subscript (o) refers to the previous peak, a is a constant relating to the positive autonomous consumption and c is the consumption function. In this equation, the consumption-income ratio in the current period (C/Y) is regarded as function of Y/Y, that is, the ratio of current income to the previous peak income..

If this ratio is constant, as in periods of steadily rising income, the current consumption income ratio is constant. During recession when current income (Y) falls below the previous peak income (Y), the current consumption income ratio (C/Y) will increase.

The relative income hypothesis is explained graphically in Fig. where C, is the long-run consumption function and C, and C are the short-run consumption functions. Suppose income is at the peak level of OY, where EY, is consumption. Now income falls to OY, Since people are used to the standard of living at the OY, level of income, they will not reduce their consumption to EY, level, but reduce it as little as possible by reducing their current saving.

Thus they move backward along the C₁, curve to point C, and be at CY, level of consumption. When the period of recovery starts, income rises to the previous peak level of OY,. But consumption increases slowly from C, to E, along the C₁, curve because consumers will just restore their previous level of savings.

If income continues to increase to OY, level, consumers will move.

upward along the C, curve from E, to E, on the new short-run consumption function C. If another recession occure at OY, level of income, consumption will decline along the C, consumption function toward C, point and income will be reduced to OY, level.

But during recovery over the long-run, consumption will rise along the steeper C, path till it reaches the short-run consumption function C. This is because when income increases beyond its present level OY,, the APC becomes constant over the long-run. The short-run consumption function shifts upward from C, to C, but consumers move along the C, curve from E, to E

But when income falls, consumers move backward from E, to C, on the C curve. These upward and downward movements from C, and C, points along the C, curve give the appearance of a ratchet. This is the rachet effect. The short-run consumption function ratchets upward when income increases in the long run but it does not shift down to the earlier level when income declines. Thus the ratchet effect will develop whenever there is a cyclical decline or recovery in income.

It’s Criticisms:

Although the Duesenberry theory reconciles the apparent contradictions between budget studies and short-term and long-term time series studies, yet it is not without its deficiencies.

1. No Proportional Increase in Consumption: The relative income hypothesis assumes a proportional increase in income and consumption.

But increases in income along the full employment level do not always lead to proportional increases in the consumptions