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Relative Income Hypothesis
Duisenberg was the first to make an attempt in this direction in the late 1940s. by using income-consumption data of 1940s, he propounded the relative-income theory of consumption, also known as relative income hypothesis.
The relative-income theory of consumption states that the proportion of income consumed by a household depends on the level of its income in relating to the households with which it identifies itself, not on its absolute income.
If income of all the households belonging to the group increases by about the same rate then the consulting level of all the households of the group including household X goes up at the same rate and vice versa. That is, ∆c/c∆Y remains the same of all the households if their income changes by the same amount.
If household X remains at the same scale of relative income and its absolute income rises, then its absolute consumption and avenges rise, but its ∆C/∆Y remains the same as it was before the rise in its income.
If household X remains on the same scale of the relative income (with income constant and the income of other households of ht group increases, then ∆C/∆Y of the household X with constant income increases.
If household X moves up form a lower income-group to a higher income-group then its ∆C/∆Y decreases.
However, the relative income hypothesis deviates from the absolute income hypothesis on the question as to what happens when household income decreases. While absolute income hypothesis holds that consumption decreases in proportion to decreases, in income, the relative income hypotheses holds that consumption does not decrease in proportion to decrease I income because, of what duesenberry calls the ratchet effect.
The ratchet effect in consumption behavior
The ratchet effect arises due to households resistance against the fall in consumption following a decrease in income. Duisenberg argues that when absolute income increases, absolute consumption increases, but when absolute income decreases, the households do not cut their consumption in proportion to the fall in their incomes. When consumption does not fall in proportion to the fall in income, then APC rises and MPC falls. This is called ratchet effect in consumption behaviour. For example, let the income of a household’s increase from $1000 per unit of time to $1100 and its consumption increase from $800 to $880. In this case, MPC = (∆C/∆Y) = 80 / 100 = 0.80 and APC = C/Y = 880/110 = 0.80. Here, MPC = APC = 0.80, but when income decreases, say form $1000 to $900, consumption decreases less than proportionately to say, form $800 to $750. In that case, MPC = (- ∆C /-∆Y) = - [50/(-100)] = 0.5 and APC = C/Y = 750/900 = 0.84. Note that MPC has decreased from 0.80 to 0.50 and APC has increased from 0.80 to 0.84.
The ratchet effect keeps the consumption at point N. when we join point C with point N as extend it further, the resulting line CsC gives the short-run consumption function. Note also that AN is the amount of disserving. It implies that when household income falls, the households resort to disserving in order to prevent a large fall in their living standards. They do so to maintain their living standards on par with their peer groups.
Furthermore, boysenberry’s consumption hypothesis implies that short-run APC is greater than ling-run APC. It can be seen that short-run average propensity to consume (APCs) is greater than the long-run average propensity to consume (APC). At point N on the short-run consumption function (CsC).
APCs = NY1/OY1
And at point M on the long-run consumption function (OC).
APCL – MY1/OY1
NY1 > MY1, Therefore, NY1 OY1 > MY1 / OY1, This proves that short-run APC is greater than the long-run APC. This is an important point of distinction between the absolute and relative income hypotheses.
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The relative-income theory of consumption states that the proportion of income consumed by a household depends on the level of its income in relating to the households with which it identifies itself, not on its absolute income.
If income of all the households belonging to the group increases by about the same rate then the consulting level of all the households of the group including household X goes up at the same rate and vice versa. That is, ∆c/c∆Y remains the same of all the households if their income changes by the same amount.
If household X remains at the same scale of relative income and its absolute income rises, then its absolute consumption and avenges rise, but its ∆C/∆Y remains the same as it was before the rise in its income.
If household X remains on the same scale of the relative income (with income constant and the income of other households of ht group increases, then ∆C/∆Y of the household X with constant income increases.
If household X moves up form a lower income-group to a higher income-group then its ∆C/∆Y decreases.
However, the relative income hypothesis deviates from the absolute income hypothesis on the question as to what happens when household income decreases. While absolute income hypothesis holds that consumption decreases in proportion to decreases, in income, the relative income hypotheses holds that consumption does not decrease in proportion to decrease I income because, of what duesenberry calls the ratchet effect.
The ratchet effect in consumption behavior
The ratchet effect arises due to households resistance against the fall in consumption following a decrease in income. Duisenberg argues that when absolute income increases, absolute consumption increases, but when absolute income decreases, the households do not cut their consumption in proportion to the fall in their incomes. When consumption does not fall in proportion to the fall in income, then APC rises and MPC falls. This is called ratchet effect in consumption behaviour. For example, let the income of a household’s increase from $1000 per unit of time to $1100 and its consumption increase from $800 to $880. In this case, MPC = (∆C/∆Y) = 80 / 100 = 0.80 and APC = C/Y = 880/110 = 0.80. Here, MPC = APC = 0.80, but when income decreases, say form $1000 to $900, consumption decreases less than proportionately to say, form $800 to $750. In that case, MPC = (- ∆C /-∆Y) = - [50/(-100)] = 0.5 and APC = C/Y = 750/900 = 0.84. Note that MPC has decreased from 0.80 to 0.50 and APC has increased from 0.80 to 0.84.
The ratchet effect keeps the consumption at point N. when we join point C with point N as extend it further, the resulting line CsC gives the short-run consumption function. Note also that AN is the amount of disserving. It implies that when household income falls, the households resort to disserving in order to prevent a large fall in their living standards. They do so to maintain their living standards on par with their peer groups.
Furthermore, boysenberry’s consumption hypothesis implies that short-run APC is greater than ling-run APC. It can be seen that short-run average propensity to consume (APCs) is greater than the long-run average propensity to consume (APC). At point N on the short-run consumption function (CsC).
APCs = NY1/OY1
And at point M on the long-run consumption function (OC).
APCL – MY1/OY1
NY1 > MY1, Therefore, NY1 OY1 > MY1 / OY1, This proves that short-run APC is greater than the long-run APC. This is an important point of distinction between the absolute and relative income hypotheses.
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