The Relative Income Hypothesis (RIH) was developed by James Duesenberry in 1949. He proposed that an individual’s consumption is based not only on their absolute income but also on their income relative to others in society, a concept known as the “demonstration effect”. Duesenberry also argued that consumption habits are persistent and that consumers are hesitant to reduce their spending levels even when income falls.
The consumption is relative to the standard of living of the society where the individual and household belong, and it is also relative to the standard of living enjoyed at the past peak level of income.
According to this hypothesis, every individual (household) tries to maintain at least the average standard of society, and if possible, they want to surpass/exceed the standard. It means consumption is independent, and there is a demonstration effect.
Similarly, the individual household tries to maintain the standard of living at the past peak level of income. This means consumption is irreversible, which is known as the Ratchet effect. आफूले एकपटक बढाएको खर्च, तलब, मूल्य वा स्तर फेरि पहिलेको अवस्थामा झर्न नसक्ने अवस्था नै Ratchet effect हो।
Though consumption is relative to the society and past status of living, in the short run, income and consumption are positive and non-proportional, but in the long run, they are positive and proportional.
To explain the short-run and long-run properties of consumption, Duesenberry defines the average saving function as
St/Yt = a + bYt/Y` ———————- (i)
Where, St = aggregate saving at ‘t’ period
- Yt = Aggregate income at ‘t’ period
- Y` = past peak level income
- a,b = Parameters
Here, St/Yt is the average propensity to save (APS), and we know that APS + APC = 1
or, St/Yt + Ct/Yt = 1
or, Ct/Yt = 1 -St/Yt
or, Ct/Yt = 1 – a -b Yt/Y` ——————- (ii)
This equation (ii) is the short-run AOC, which shows that, if income (Yt) increases, the APC in the short run declines, which means the APC of reaching people is lower than that of the poor. Now, for short-run MPC, we have
Ct /Yt = 1 – a – bYt/Y`
or, Ct = (1-a)Yt – bY2t/Y`
or, ΔCt/ΔYt = 1 -a – 2bYt/Y`
or, MPC = 1-a-2bYt/Y`
Now, if we compare equations (ii) and (iii), we find that
APC > MPC and APC declines as income increases. This means that in the short run, consumption and income are positively related and non-proportional.
According to this hypothesis, in the long run, income grows along a constant trend, which means that the income in the previous period itself represents the past peak level of income.
i.e. Y` = Yt -1
Let ‘g’ be the long-run growth rate of income, the current income is
Yt = (a +g) Yt -1
or, Yt = (1 +g)Y` (Y` = Yt -1)
or, Yt/Y` = (1 +g) ———– (iv)
Now, substituting the value from equation (iv) into equation (ii), we get the long-run APC as:
Ct/Yt = 1 – a – bYt/Y`
or, Ct/Yt = 1 – a -b (1 +g) ——– (v)
This equation (v) is the long-run APC, and now for the long-run MPC
Ct/Yt = 1 – a -b (1+g)
or, Ct = {(1-a-b(1+g)}Yt
or, dCt/dYt = d(1 -a-b(1+g)Yt
or, dCt/dYt = 1 -a -b (1+g) ———- (vi)
This is long-run MPC, and if we compare equations (v) and (vi), we find that both APC and MPC are equal and constant. This means income and consumption are positive and proportional in the long run.
Reconciliation of Short-run and Long-run Consumption Function
This hypothesis posits that consumption and income are positively related and non-proportional in the short run, due to the demonstration and Ratchet Effect. It means if the income of the individual or household declines, the consumption does not fall in the same proportion because they try to maintain the past standard of living (while maintaining the peak level of income in the past), it is called the Ratchet Effect, and also the average standard of society (demonstration effect).
This effect makes the short-run consumption function positive and non-proportional. But in the long run, income is growing along a constant trend, which has upgraded the standard of the whole society without changing its relative position. It makes the long-run consumption function positive and proportional. It means in the long run, the standard of the individual or household is improving on average, but they belong to the same society or income group, and their consumption is of the same proportion of the income.
Here,
The economy is initially at Eo with OYo income and EoYo consumption. Now, assume that there are disturbances and negative shocks in the economy (e.g., COVID-19), which reduce income. Still, consumption does not decline in proportion to income and follows the non-proportional line SRCFo. During this period, people dissave, borrow, and sell their assets to maintain the standard of living at the past peak level of income OY0.
When income falls to OY`, the economy starts recovery, and so income increases, but consumption does not increase in the same proportion because s/he have to pay the loan taken during the crisis. Once income increases to OY1, which takes a long period, the standard of the whole society is upgraded, and the SRCF itself shifts upward to SRCF1 with E1Y1 consumption at OY1 income.
If we compare these two long-run points, then we find that the increase in income and consumption is equal and proportional.
i.e OY1 – OYo/OYo = E1Y1 – EoYo/EoYo