Relative Income Hypothesis

The Relative Income Hypothesis: Consumption as a Social Phenomenon

The Relative Income Hypothesis, developed by James Duesenberry, challenges the notion that consumption is solely determined by absolute income. Instead, it posits that consumption decisions are heavily influenced by an individual’s relative income compared to others in their social group and their own past income levels.

This hypothesis rests on two core principles:

• Interdependence of Consumer Preferences: Consumption patterns are driven by social comparisons. Individuals strive to maintain a standard of living comparable to their peers, particularly those with higher incomes, leading to a “keeping up with the Joneses” mentality.
• Irreversibility of Consumption Habits: Consumers resist lowering their consumption standards even when their income declines, a phenomenon known as the Ratchet Effect. This resistance stems from the desire to maintain their accustomed lifestyle.

The Ratchet Effect

The Ratchet Effect explains why the short-run consumption function exhibits non-proportionality - during economic downturns, people reduce their consumption less proportionally to their income decline, relying on savings or incurring debt to uphold their living standards. Conversely, during recovery, they increase consumption gradually, prioritizing savings replenishment.

Mechanism

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1. Peak Income: Assume the economy is initially at peak income level $O{Y}_1$, with consumption at $E_1{Y}_1$
2. Income Decline: If income falls to $O{Y}_0$, the Ratchet Effect comes into play. Instead of reducing consumption proportionally to the new income level $E_0{Y}_0$, individuals try to maintain their previous consumption standards.3 They move backward along the short-run consumption function $C{S}_1$ to point $C_1$, consuming $C_1{Y}_0$
3. Recovery: As the economy recovers and income rises back to $O{Y}_1$, consumption does not immediately jump back to the previous peak level. Instead, it increases gradually along the long-run consumption function $C_L$ from $E_1$ to $E_2$. The short-run consumption function shifts upwards from $C{S}_1$ to $C{S}_2$, but consumers stick to the $C_L$ curve.
4. Subsequent Decline: If income falls again, consumers move backward from $E_2$ to $C_2$ on the $C{S}_2$ curve, again demonstrating the resistance to reducing consumption proportionally to income decline.

This pattern of upward and downward movements creates a ratcheting effect along the long-run consumption function. The short-run consumption function “ratchets upward” during periods of income growth but resists downward shifts during contractions. Essentially, consumption levels “stick” to a higher level once reached and are reluctant to decline.

The Relative Income Hypothesis, coupled with the Ratchet Effect, helps explain why:

• Richer households tend to save more in the short run as they feel less pressure to emulate others’ consumption patterns.
• Long-term economic growth does not necessarily translate to a proportional increase in the aggregate saving rate, as consumers aim to maintain their relative consumption levels despite rising overall incomes.

The sources illustrate this theory with a long-run consumption function (CL) and short-run consumption functions (CS1 and CS2) that depict the upward “ratcheting” behavior as income fluctuates. However, the sources also highlight some criticisms of this hypothesis, such as the unrealistic assumption of stable income distribution and the potential for consumer behavior to be slowly reversible over time.