Relative Income Hypothesis

The relative income hypothesis puts forth the idea that an individual's utility regarding consumption and saving depends on their income and income relative to other people rather than its absolute value about the standard of living. The hypothesis mainly aimed to explain savings behavior in the United States.

According to this theory, people are more concerned with their income and consumption compared to those around them than with their past income and consumption patterns. Therefore, lower-income people may spend more of their earnings than their peers of higher socioeconomic status to reduce the disparity in their consumption levels and quality of living.

• The relative income hypothesis refers to a condition where individuals are more concerned with their income and consumption than those around them rather than the standard of living.
• An attitude of savings and consumption is more dependent on the income of others. This conforms to the notion that people are inherently conscious of the status quo.
• American Economist James Duesenberry's Relative income hypothesis was first proposed in the Income, Saving, and the Theory of Consumer Behavior in 1949.
• There are four major components of the relative income hypothesis. 

The relative income hypothesis states that an individual's attitude toward consumption and saving is influenced more by their income than others. The level of consumption obtained in a previous time also influences current consumption, in addition to current absolute and relative income levels. Once a family attains a certain level of consumption, they find it challenging to lower it.

The theory of consumption became a major area of study in macroeconomics following World War II. The consumption expenditure at that time was around two-thirds of the Gross Domestic Product (GDP), and experts worried that the economy might revert to high unemployment. 

The book "Income, Saving, and the Theory of Consumer Behavior," written by American economist James Duesenberry, an American economist, was published in 1949. It challenged Keynes' notion of consumption behavior by introducing psychological factors associated with habit formation and social interdependencies based on relative income concerns.

According to Duesenberry, "the intensity of any individual's desire to increase his consumption expenditure is determined by the ratio of his expenditure to some weighted average of the expenditures of others with whom he interacts." 

Duesenberry's relative income hypothesis has four important components. They are the following -

1. Individuals are more concerned with their relative well-being than their absolute well-being.
2. Poor people spend a greater portion of their income than rich people to narrow the consumption gap.
3. Current absolute and relative income levels and previous consumption levels determine present consumption.
4. Consumption within a family is influenced by its income compared to other families.

Let us understand the concept better with the help of the relative income hypothesis diagram.

According to Duesenberry's relative income hypothesis, consumption is not very responsive to present income at any given time. People make decisions about their spending based on their relative income situation. Their spending habits alter if their relative position changes as their earnings increase or decrease over time. 

In the above relative income hypothesis diagram, when income is at the I level, consumption is at the C level. As soon as income declines to I1, the people who have already reached the income level of I do not prefer to consume at the C1 level. This is because of their previous standard of living and trying to maintain the consumption level at the same level.

But in the long run, the consumption falls to C1. Now income further falls to the I2 level, and consumption falls to the C2 level because people want to maintain their previous standard of living. But supposedly, the income increases to I3 in the long run. Then the consumption level reaches the C3 level only in the long run and not in the short run.

Thus the cyclical changes in the business cycles affect the consumption pattern in the short run. Otherwise, only the long-run effects of consumption levels on income are apparent.

Let us look at a relative income hypothesis example to understand the concept better. 

Alex earns $500 a month, and their consumption is $200 per month. Due to the recession, their income falls to $300 and their consumption to $170. But after the recession, the income steadily rises to $1000, and the consumption level rises to $400. But it does not rise at the same rate as their income levels.

The consumption patterns do not fall at the same rate as the decline in the income levels because the consumption levels of low-income groups are relative to the consumption levels of high-income groups. The low-income groups try to reduce this gap by consuming at the same standard of living, and once the income reaches a particular level, the consumption increases but not at the same level.

Absolute and relative income hypotheses have a few key differences between them. Economist John Maynard Keynes introduced the former concept under the theory of consumption. Economist James Duesenberry introduced the latter concept under "Income, Saving, and the Theory of Consumer Behavior."

According to the absolute income hypothesis, an individual allocates disposable income between spending and saving. In contrast, in the relative income hypothesis, current income has little impact on consumption. People spend in line with their relative income situation.

This has been a guide to what is Relative Income Hypothesis. We explain it with its diagram, example, and comparison with the absolute income hypothesis. You can learn more about finance from the following articles –

• Econometrics
• Permanent Income Hypothesis
• Factor Investing