Relative income hypothesis

Relative income hypothesis

Introduction :- According to keynesian Current level of income determines the consumption of an individual and also society.

He emphasised that absolute size of income determines the consumption.
This theory is known as absolute income hypothesis .In this hypothesis, according to him, as income increases consumption increases but not by as much as the increase in income..i.e. 0<APC<1.

After that,James Duesenberry has propounded that consumption hypothesis which is depends on income of an individual relative to incomes of others rather than the absolute size of his own income.His theory called relative income hypothesis of consumption function.
according to him, the consumption of a person does not depend on his current income but on certain previously reached income level.Therefore,the Consumption of a  individual also depend upon the other.
Duesenberry says strong tendencies exist in our society for people to emulate their neighbours and to strive toward a higher standard of living.As result, if the incomes of individuals increase so as to leave the distribution of income unchanged, consumption increases in proportion to the increase in income.

According to Duesenberry, if we want to understand the problem of consumer behavior in real, then we have to recognize the social nature of the consumer behavior from the beginning.

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DUESENBERRY EFFECT OR DEMONSTRATION EFFECT :-

The tendency It is about constantly rising towards higher consumption levels and getting richer Compete with the consumption structure of neighbors and peers. Thus consumer's preferences of the Consumption depend on each other. This is called the Dussenberry Effect or Demonstration Effect.

However, in some communities
Consumption expenditure determines through the difference in people's relative income. A rich individual's APC will be relatively low as he will need a small portion of his income to maintain his consumption structure. On the other hand, relatively poor individual will have higher APCs as they strive to reach the consumption standards of their neighbors or peers. This clarifies the long-term stability of the APC This is because the overall low and high APC will be balanced. Such as Even if the absolute amount of income in a country is higher, it will still affect the economy as a whole APC will remain stable at the highest neutral level of revenue.

The second part of Dusenbury's theory is the past peak of income hypothesis that explains short-term fluctuations in consumption function And refutes Keynes's assumption that the consumer relationship is reversible. This Establish,the hypothesis that consumption will increase and Slowly adjust to a higher level during the prosperity period.Onces people Reach a certain high level of income and Consumption.they get used to this standard of living. Even in a recession, they are unwilling to give up their consumption structure.

RATCHET EFFECT:

The other significant part of Duesenberry’s relative income hypothesis is that it suggests that when income of individuals or households falls, their consumption expenditure does not fall much. This is often called a ratchet effect.

In Dusenbury's words, it is easier for a family to control higher expenses in the beginning, but it is more difficult to reduce expenses at a higher level.it's just because of demostration effect.People do not want to show to their neighbours that they no longer afford to maintain their high standard of living.

Now we will discuss relative income hypothesis through the diagrm. CL is a long run Consumption function and
Cs1 and Cs2 are short-run consumption functions.Assume a OY1 is a maximum level of income .At the level where consumption is E1 Y1. Now Income falls to OY0. Because of People are used to the standard of living at the OY1 level of income. Therefore they
Will not reduced their Consumption to E0 Y0 level.they go backwards on the Cs1 curve and they Will reach the C1 point and remain at the C1 Y0 level of consumption.
when recovery period begins, then the income increases to the level of the previous income oY1 .But consumption gradually increases from C1 to E1 along the Cs1 curve.
This is because people will re-establish their previous level of savings.If income increases at the OY2 level, the consumer has the new short-run consumption function Cs2 along with C1 curve will move upwards from E1 to E2.
When recession will come At OY2 level of income, then income will fall to OY1 level. Then consumption will fall from E2 to C2 along with Consumption curve Cs2.
But in the long run during the recovery Consumption will increase along with the long-term consumption function CL until it reaches the short-term consumption function Cs2.
Here we can see that when income increases in long run , short run Consumption function also increases.But when income falls, Consumption goes down Sliding does not reach the first level.

CRITICISMS:-

1)No Proportional Increase in
Consumption:-

The Assumption of relative income theory is that there is proportion increases in income and consumption. But an increase in income on full employment does not always lead to a proportional increase in consumption.

2)No Direct Relation between
Consumption and Income- This principle is based on the assumption that
There is a direct correlation between income and consumption but this is not supported on the basis of experience. Consumption does not always decrease as a result of the trade recession. For example 1948-49
And consumption did not decline during the 1974-75 trade recession.

3)Distribution of Income not Unchanged:-
The theory presented is based on the assumption that there is a change in the overall income level Even so, owning one is still beyond the reach of the average person. If your income increases At the same time income is redistributed in the direction of greater equality, then relatively poor
And the APC of all those belonging to relatively wealthy families will decrease. like this When revenue increases, the consumption function will not move upwards from Cs1  to Cs2.

4)Reversible Consumer Behavior-
According to Michael  Evans, "consumer behavior has Slightly changeable  over time rather than completely changeable . Then as much time passes as the previous maximum level (peak) ,The last maximum revenue level will have an equally small effect on current consumption".If we also know that a consumer has reached their previous highest income level And how it was spent, it is still not possible to know how it is now
Will consume.

5). Neglect of Other Factors:-
It is based on the Assumption that changes in consumer's expenditure is correlated with the previous maximum lavel of income. This theory is weak from this point of view that Ignoring urbanization, consumer age,. Influencing changes in structural behavior, new consumer, other factors such as asset arrival perceptions, etc.