MACROECONOMIC THEORY - I

F.Y. B.Sc. Economics Div (A) & (C); SSE (Batch 2014-2017)
Faculty: Sushma

RELATIVE INCOME HYPOTHESIS

 Relative income hypothesis states that the satisfaction (or utility) an individual
derives from a given consumption level depends on its relative magnitude in the
society (e.g., relative to the average consumption) rather than its absolute level. It
is based on a postulate that has long been acknowledged by psychologists and
sociologists, namely that individuals care about status.

 In economics, relative income hypothesis is attributed to James Duesenberry, who

investigated the implications of this idea for consumption behavior in his 1949
book titled Income, Saving and the Theory of Consumer Behavior.

 At the time when Duesenberry wrote his book, the dominant theory of
consumption was the one developed by the English economist John Maynard
Keynes, which was based on the hypothesis that individuals consume a
decreasing, and save an increasing, percentage of their income as their income
increases. This was indeed the pattern observed in cross-sectional consumption
data: At a given point in time the rich in the population saved a higher fraction of
their income than the poor did. However, Keynesian theory was contradicted by
another empirical regularity: Aggregate saving rate did not grow over time as
aggregate income grew. Duesenberry argued that relative income hypothesis
could account for both the cross-sectional and time series evidence.
 MACROECONOMIC THEORY - I
F.Y. B.Sc. Economics Div (A) & (C); SSE (Batch 2014-2017)
Faculty: Sushma

Duesenberry vs. Keynes

 Duesenberry - Consumption expenditure is not exclusively dependent upon

absolute level of income of individuals
 Keynes believed consumption depends upon absolute level of income

 Duesenberry - Consumption levels are irreversible and not reversible over

time
 Keynes – Consumption–income relationship is reversible i.e. people will
reduce consumption when their income falls exactly along the same path as
is followed when there is rise in income

 Duesenberry - Every individual’s consumption behaviour is not

independent but interdependent of the behaviour of every other individual
 Keynes – Consumption pattern of one group of consumers is independent
of that of others

 Duesenberry claimed that an individual’s utility index depended on the ratio of

his or her consumption to a weighted average of the consumption of the others.

 Despite its intuitive and empirical appeal, Duesenberry’s theory has not found
 MACROECONOMIC THEORY - I
F.Y. B.Sc. Economics Div (A) & (C); SSE (Batch 2014-2017)
Faculty: Sushma

wide acceptance and has been dominated by the life-cycle/permanent-income

hypothesis of Franco Modigliani and Richard Brumberg (published in 1954) and
Milton Friedman (1957).

 These closely related theories implied that consumption is an increasing function

of the expected lifetime resources of an individual and could account for both the
cross-sectional and time series evidence. However, starting with the 1970s,
inability of these theories to explain some other puzzling empirical observations
as well as the increasing evidence that people indeed seem to care about relative
income have generated renewed interest in relative income hypothesis.

In a Nutshell:
 To understand consumer behaviour, it’s important to fully recognize the social
character of consumption patterns.
 Social character of consumption patterns implies tendency in human beings “to keep
up with the Joneses” (meaning - strive to match one's neighbours in spending
and social standing).
 In other words, every individual strives constantly to attain a higher level of
consumption and to emulate the consumption patterns of his rich neighbours and
associates.
 Thus, consumer’s preferences are interdependent.

 Relative Income Hypothesis comprises 2 parts:

a) The fraction of income consumed by a household, its average propensity to
consume, is determined by its relative income, i.e. by its position in the INCOME
 MACROECONOMIC THEORY - I
F.Y. B.Sc. Economics Div (A) & (C); SSE (Batch 2014-2017)
Faculty: Sushma

DISTRIBUTION

b) “Past Peak of Income” hypothesis - During a period of prosperity, consumption

will increase and gradually adjust itself to a higher level. Once people get
accustomed to this standard of living, they are not prepared to reduce their
consumption pattern during a recession. It’s hard for a family to reduce its
expenditures from a higher level to a lower level. Thus, as income falls,
consumption falls but proportionately less than the decrease in income because
consumer dissaves to maintain consumption