Relative Income Hypothesis
Studies were made to resolve the conflict and inconsistencies between Keynes absolute income hypothesis and observations made by Kuznets.
Former hypothesis said that consumption is a stable function of current income and his statement was based on fundamental psychological law. Also, as per him in the short run Marginal propensity to consume (NYSE:MPC) < Average propensity to consume (NYSE:APC).
Further, as per Kuznets observation both MPC and APC are equal in the long run i.e. MPC=APC.
Thus, one of the earliest attempts to solve the conflict between short and long run consumption was Relative Income Hypothesis (NASDAQ:RIH). - Developed by James Duesenberry who believed that the basic consumption function was long run and potential. This means that average fraction of income consumed does not change in long run, but there may be variation in short run between consumption and income.
Duesenberry's RIH is based on two hypothesis :
I. Relative Income Hypothesis (RIH);
II. Past Peak Income Hypothesis.
Relative Income Hypothesis (RIH): RIH states that an individuals attitude to consumption and saving is dictated more by his income in relation to others than by abstract standard of living i.e.consumption depends not on the absolute level of income but on the relative income. income relative to income of the society in which individual survives.
The outcome of this hypothesis is that the individuals APC depends on his relative position in income distribution. Families with relatively high incomes experience lower APCs and families with relatively low incomes experience high APCs. If, on the other hand, income distribution is relatively then APC will not change.
Thus, in the aggregate we get a proportional relationship between aggregate income and aggregate consumption. Hence the RIH says that there is no apparent conflict between the results of cross-sectional budget studies and the long run aggregate time-series data.
Past Peak Income Hypothesis: This states that, the present consumption is not influenced merely by present levels of absolute and relative income, but also by levels of consumption attained in previous period. It is difficult for a family to reduce a level of consumption once attained. The aggregate ratio of consumption to income is assumed to depend on the level of present income relative to past peak income.
This hypothesis says that consumption spending of families is largely motivated by the habitual behavioral pattern. If current incomes rise, households tend to consume more but slowly. This is because of the relatively low habitual consumption pattern and people adjust their consumption standards established by their previous peak income slowly to their present rising income levels.
On other hand, if current incomes decline these households do not immediately reduce their consumption as they find it difficult to reduce their consumption established by the previous peak income.
Thus, during depression, consumption rises as a fraction of income and during prosperity;consumption does increase slowly as a fraction of income. This hypothesis thus generates a non-proportional consumption function.
Duesenberry's explanation of short run and long run consumption function and the reconciliation between these two types of consumption function are explained with the help of following graph:
CSR = Cyclical rise and fall in income levels producing a non-proportional consumption-income relationship.
CLR = Proportional consumption-income relationship.
As national income rises consumption grows along the long run consumption, CLR. Note that at income OY0 aggregate consumption is OC0. As income increases to OY1, consumption rises to OC1.
Now, if there is recession, leading to a fall in income level to OY0 from the previously attained peak income of OY1, then second hypothesis comes into operation where households will maintain the previous consumption level what they enjoyed at the past peak income level. This means, they will hesitate in reducing their consumption standards along the CLR.
Consumption will not decline to OC0, but to OC1 (> OC0) at income OY0. At this income level, APC will be higher than what it was at OY1 and the MPC will be lower.
In case income rises, consumption rises along CSR since people try to maintain their habitual consumption standards influenced by previous peak income. Once OY1 level of income is reached consumption would then move along CLR. Thus, the short run consumption is subject to what Duesenberry called the ratchet effect. It ratchets up following an increase in income levels, but it does not fall back downward in response to income declines.
Duesenberry contended that the utility of consumers are depended not so much on their absolute income but rather on their relative income, both current income relative to previous income and current income relative to the income of others in society with whom the consumer feels in competition with. Consequently, economy-wide increases in absolute incomes which do not affect the relative income distribution will have little impact on the behavior of consumers in terms of the share of income consumed.
The relative income hypothesis (RIH) is somewhat at odds with the traditional microeconomic theory of consumer behavior since it violates the key assumption that an individual¡¦s preferences should be independent of the consumption behavior of others. This is one of the reasons for the failure of the RIH and has been dominated by the life-cycle/permanent-income hypothesis of Franco Modigliani and Richard Brumberg (published in 1954) and Milton Friedman (1957).
RIH Does not Exist :- Permanent Income Hypothesis
Another attempt to reconcile three sets of apparently contradictory data (cross-sectional data or budget studies data, cyclical or short run time-series data and Kuznets long run time-series data) was made by Nobel Prize winning Economist, Milton Friedman in 1957. Like Duesenberrys RIH, Friedmans hypothesis holds that the basic relationship between consumption and income is proportional.
According to Friedman consumption depends neither on absolute income, nor on relative income but on permanent income, which is based on expected future income.
Thus, he finds a relationship between consumption and permanent income. His hypothesis is then described as the permanent income hypothesis (NASDAQ:PIH).
Friedmans basic argument is that permanent consumption depends on permanent income. The basic relationship of PIH is that permanent consumption is proportional to permanent income that exhibits a fairly constant APC i.e. C = kYp where k is constant and equal to APC and In essence, it suggests that consumption as the appropriate proportion of the perceived ability of consumers to consume in the long run. Wealth, W, is defined as the present discounted value of current and future total income receipts, inclusive of income from assets. Under the assumption that the household is infinitely lived, permanent income can be defined as that level of income which, when received in perpetuity, has a present discounted value exactly equal to the wealth of the household.
In giving the hypothesis, Friedman assumes the transitory components to be uncorrelated across consumption and income, and with their respective permanent components.
The second of these assumptions follows from the definitional decomposition and the nature of transitory components. The first implies that irregular income will not result in unplanned consumption. Friedman defends this assumption by arguing that transitory income changes are likely to be reflected in changes in asset holdings. Further, since the consumption definition includes only the flow of services from goods, transitory income disbursed on durable goods may still be classified as unplanned savings.
This proportionate relationship between the permanent components of consumption and income is readily reconciled with the non proportionate aggregate relationship typically observed empirically in cross-sections and short-run aggregate data studies. This is as a consequence of low-income brackets including a greater proportion of households with negative transitory income, and high-income brackets including a greater proportion of households with positive transitory income.
A major difficulty in attempting to test the PIH empirically is that permanent income is not observable. This necessitates the use of some proxy or means of estimating permanent income. In the empirical implementation of the permanent income hypothesis using time-series data, Friedman utilized an adaptive mechanism to relate permanent income to current and past measured income, with the greatest weight attached to current income and declining weights attached to income further in the past.
The permanent income hypothesis provides intuitive explanations for many of the more important aspects of consumer behaviour with, the fact that over long periods of time, variations in permanent income reflect variations in aggregate income growth in the economy. On the policy front it can guide policymakers as to the most effective policy course by, for example, explaining the relatively small economic impact which temporary tax cuts and is compared with a permanent reduction.
In addition, the success of the PIH approach was not only built on its solid grounding in microeconomic utility maximising theory but also on its empirical explanatory power being consistent, as it was, with both the short-run and long-run evidence. Over the long-run, it suggested that wealth (i.e. permanent income) was the main determining factor in terms of consumption and that the consumption to wealth ratio was a stable one.
As regards the short-run it encompasses the Keynesian approach by explaining why over the business cycle consumption fluctuates less than disposable income as a result of consumption smoothing by consumers ¡V which has the effect of evening out consumption in the face of fluctuating income.
Naysayers generally agree with - RIH: An ensuing criticism of the PIH is centered on the assumption of an adaptive relationship between permanent and measured income. This criticism hinges on the observation that such expectations are entirely backward-looking, in the sense that expectations are only revised in response to past movements in income, and such revisions are in general sluggish, which suggests the possibility of systematic expectation errors.
However, it is not a tenable proposition that rational economic agents, who are assumed to be optimizing subject to constraints in all other regards, would not seek to revise their expectation formation mechanism, and the information on which it draws, in such circumstances.
Despite its theoretical dominance, the empirical case in favour of the permanent income hypothesis is weak. Contrary to one of its basic implications, a growing body of evidence suggests that rich households save a higher proportion of their permanent income than poor households. We propose an overlapping-generations economy where households care about
relative consumption. As a result, an individual¡¦s consumption is driven by the comparison of his lifetime income and the lifetime income of his reference group; a permanent income version of Duesenberrys (1949) relative income hypothesis. Across households the savings rate increases with income while aggregate savings are independent of the income. Duesenberry's theory includes important institutional factors that cannot be replaced by the permanent income hypothesis or the life cycle hypotheses.
Relative income hypothesis has other important economic implications. Perhaps the most obvious implication is that consumption creates negative externalities in the society, which are not taken into account in individual decision-making. If individuals consume, and therefore work, to increase their status, then they will tend to work too much relative to the socially optimal level and hence income taxation could improve the social welfare.
Relative income hypothesis is a special case of negatively interdependent preferences according to which individuals care about both their absolute and relative material payoffs. In 2000 Levent Kockesen, Efe Ok, and Rajiv Sethi showed that negatively interdependent preferences yield a higher material payoff than do selfish preferences in many strategic environments, which implies that evolution will tend to favor the emergence of negatively interdependent preferences. This could be regarded as one explanation for the empirical support behind relative income hypothesis.