THE RELATIVE INCOME HYPOTHESIS THEORY OF CONSUMPTION

Ø  RELATIVE INCOME HYPOTHESIS THEORIES OF THE CONSUMPTION

Ø  MACRO ECONOMICS 

Ø  INTRODUCTION

1. GIVEN BY JAMES DUESENBERRY
2. BASED ON REJECTION OF TWO FUNDAMENTAL ASSUMPTIONS OF THE CONSUMPTION OF THE THEORY OF KEYNES:-

a)    EVERY INDIVIDUAL’S CONSUMPTION BEHAVIOR IS NOT INDEPENDENT BUT INTERDEPENDENT OF THE BEHAVIOR OF OTHER INDIVIDUAL

b)    CONSUMPTION RELATIONS ARE IRREVERSIBLE AND NOT REVERSIBLE IN TIME

3. DUSSENBERY SAYS STRONG TENDENCIES EXIST IN OUR SOCIETY FOR PEOPLE TO EMULATE THEIR NEIGHBOR AND TO STRIVE TOWARDS A HIGHER STANDARD OF LIFE.CONSUMER’S PREFERENCES ARE INTERDEPENDENT AND IT IS HOWEVER DIFFERENCE IN RELATIVE INCOMES THAT DETERMINE THE CONSUMPTION EXPENDITURE IN THE COMMUNITY.
4. IF THE INCOME OF INDIVIDUAL INCREASES SO AS TO LEAVE THE DISTRIBUTION OF INCOME CHANGED CONSUMPTION INCREASES IN PROPORTION TO THE INCREASE IN INCOME. THE BASIC FUNCTION IS THE LONG RUN

5. STRESS ON RELATIVE INCOME AS A DETERMINANT OF CONSUMPTION INSTEAD OF ABSOLUTE
6. CONSUMPTION OF A PERSON DES NOT DEPEND UPON HIS CURRENT INCOME BUT ON CERTAIN PREVIOUSLY REACHED INCOME LEVEL

7.     FOR EXAMPLE IF THE INCOME OF ALL INDIVIDUAL IN A SOCIETY INCREASE BY THE SAME PERCENTAGE THEN HIS RELATIVE INCOME WOULD REMAIN THE SAME THOUGH HIS ABSOLUTE INCOME WOULD HAVE INCREASED.

8.     ACCORDING TO DUSSENBURY BECAUSE HIS RELATIVE INCOME HAS REMAINED THE SAME THE INDIVIDUAL WILL SPEND THE SAME PROPORTION OF HIS INCOME ON CONSUMPTION AS HE WAS DOING BEFORE THE ABSOLUTE INCREASE IN INCOME.AVERAGE PROPENSITY WILL REMAIN THE SAME DESPITE THE INCREASE IN HIS ABSOLUTE INCOME.IN THE LONG RUN THE COMMUNITY WOULD CONTINUE TO CONSUME THE SAME PROPORTION OF INCOME AS THE INCOME INCREASES.

9. THE SECOND PART OF DUSENBURRY THEORY IS THAT THE PAST PEAK INCOME. HYPOTHESIS WHICH EXPLAINS THE SHORT TERM CONSUMPTION FUNCTIONS ARE REVERSIBLE. THE HYPOTHESIS SAYS THAT DURING A PERIOD OF PROSPERITY,CONSUMPTION WILL INCREASE AND GRADUALLY ADJUST ITSELF TO HIGHER LEVEL. ONCE WE ARE USED TO PARTICULAR STANDARD OF LIVING,NOT ABLE TO REDUCE IT IN RECESSION.
10. AS INCOME FALLS CONSUMPTION DECLINE BUT PROPORTIONATELY LESS THAN DECREASE IN INCOME BECAUSE THE CONSUMER DIS SAVE TO SUSTAIN CONSUMPTION. ON THE OTHER HAND WHEN INCOME INCREASES DURING RECOVERY PERIOD,CONSUMPTION RISE GRADUALLY WITH A RAPID INCREASE IN SAVING.

• COMBINES HIS TWO RELATED HYPOTHESIS IN THE FOLLOWING FORM:-

_o     C_t/Y_t =a-b Y_t/Y₀

o    C = CONSUMPTION= INCOME t= CURRENT PERIOD AND (0)  REFERS TO PREVIOUS PEAK

o    a = CONSTANT RELATING TO POSITIVE AUTONOMOUS CONSUMPTION AND b IS THE CONSUMPTION FUNCTION

_o     CONSUMPTION RATIO IN THE CURRENT PERIOD (C_t/Y_t )IS REGARDED AS FUNCTION OF RATIO OF THE CURRENT INCOME TO PREVIOUS PEAK.(Y_t/Y₀  )

o    IF THIS RATIO IS CONSTANT AS IN PERIODS OF STEADILY RISING INCOME THE CURRENT INCOME RATIO IS CONSTANT. DURING RECESSION THE CURRENT INCOME FALLS BELOW THE PREVIOUS PEAK INCOME THE CURRENT CONSUMPTION INCOME RATIO WILL INCREASE.

• DIAGRAM

• D
• EXPLANATION
• CL =LONG RUN CONSUMPTION
• CS1 AND CS2 ARE SHORT RUN CONSUMPTION
• INCOME AT PEAK LEVEL IS OY1 WHERE E1Y1 IS CONSUMPTION.
• INCOME FALLS TO YO PEOPLE USED TO STANDARD OF LIVING WILL NOT REDUCE THEIR CONSUMPTION TO E0Y0 LEVEL BUT REDUCETHEIR SAVING. WHEN THE PERIOD OF RECOVERY STARTS INCOME RISES TO PREVIOUS PEAK LEVEL OF OY1 . BUT CONSUMPTION INCREASE SLOWLY FROM C1 TO E1 BECAUSE THEY RESTORE THEIR SAVING. IF INCOME CONTINUE TO INCREASE OY2 LEVEL CONSUMER  CONSUMPTION WILL MOVE  WILL E1 TO E2 LEVEL BUT IF ANOTHER RECESSION OCCURS CONSUMPTION WILL DECLINE ALONG THE CS2 AND INCOME WILL REDUCED TO OY1 CONSUMPTION TOWARDS C2 POINT BUT DURING RECOVERY OVER THE LONG RUM CONSUMPTION WILL RISE ALONG THE LONG RUM CONSUMPTION FUNCTION.WHEN INCOME INCREASES BEYONF PRESENT LEVEL APC WILL BECOME CONSTANT.
• RATCHET EFFECT
• THE SHORT RUN CONSUMPTION FUNCTION RATCHETS UPWARD WHEN INCOME INCREASES IN THE LONG RUM BUT IT DOES NOT SHIFT DOWN TO EARLIER LEVEL WHEN INCOME DECLINES.
• CRITICISM

1. RELATIVE INCOME HYPOTHESIS ASSUMES A PROPORTIIONAL INCREASE IN INCOME AND CONSUMPTION BUT INCREASE IN INCOME ALONG THE FULL EMPLOYMENT LEVEL DO NOT ALWAYS LEAD TO PROPORTIONAL INCREASE IN THE CONSUMPTION.
2. NOT EMPIRICALLY TESTED THE ASSUMPTION OF DIRECT RELATION BETWEEN CONSUMPTION AND INCOME TO BE DIRECT
3. WRONG ASSUMPTION OF DISTRIBUTION OF INCOME REMAINS CONSTANT
4. THE CONSUMER BEHAVIOR IS SLOWLY REVERSIBLE OVER TIME INSTEAD OF BEING TRULY IRREVERSIBLE
5. IT NEGLECT OTHER FACTORS THAT INFLUENCE CONSUMER SPENDING SUCH AS ASSET HOLDING,URBANIZATION ,CHANGES IN AGE COMPOSITION ETC
6. UNREALISTIC ASSUMPTION THAT CONSUMER PREFERENCE ARE INTERDEPENDENT WHEREBY A CONSUMER EXPENDITURE IS RELATED TO CONSUMPTION PATTERN OF HIS RICH NEIGHBOR.