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Theories of Consumption

Relative Income Theory of Consumption

Mr. James Stemble Duesenberry, an economist of America, posited a theory for consumer behavior whose main purpose is to focus on the relative income rather than the absolute income of an individual which is the determining factor of consumption of that particular individual. Additionally, Duesenberry pointed out that in the consumption of theory of Keynes that the consumption of an individual is not dependent upon his present income but on the already reached level of income According to the relative income hypothesis of Duesenberry, the consumption of a person depends upon his relative position within the income distribution within the society rather than the function of his absolute income. i.e. his spending is contingent upon the income relative to the other individual’s income within the society, for instance, if the income of all members of a society increases by an equivalent percentage then the absolute income of any one person of the society would increase however, the relative of that particular person would remain same

As stated by James Stumble Duesenberry, ( Theories of Consumption ( Theories of Consumption ) the relative income of that individual would be the same then he would be spending the same percentage of his income on the consumption as he was spending beforehand the increase in his absolute income that shows that his Average propensity to consume (APC) would continue to remain same regardless of the increased absolute income.

As shown by the empirical successes made by Kuznets that for a long time the Average propensity to consume (APC) tends to remain constant. Presently, the relative income hypothesis of Duesenberry states in an extensive period the society would consume the same percentage of the income even if the income increase. According to the theory, the percentage of the savings of an individual whose income is low would not rise plentiful with the rise in income. The reason behind this is that with the rise in incomes of all members of the society by the equivalent percentage. The relative income of all of those members would not be affected thus they would be spending a similar percentage of their income as before. This theory is applied to all of the individuals and houses. Consequently, this theory suggests assuming that relative distribution of the income stays constant with the rise of income within the society, the average propensity to consume (APC) of that society would then remain constant

Therefore, the outcome of the relative income hypothesis is different from the Keynesian’s consumption theory, which states that if the absolute income of a society increases, the society would spend a lesser percentage of its income on the expenditures which shows that average propensity to consume (APC) would decrease.

Another important point in ( Theories of Consumption ) the relative income theory is that it suggests that with the rise in the income of society the relative distribution of the income stays constant and the aggregate consumption function shifts upwards and it does not change along the similar aggregate consumption. As long as the income raises the movement with the identical consumption function curves indicates a fall in the average propensity to consume (APC). The relative income hypothesis of Duesenberry proposes that if the income rises grows the curve of the consumption function shifts above hence the average propensity to consume (APC) stays constant.

Read also: LDC, Less Developing Countries Debt Crisis


Implications of Relative Income Theory of Consumption

Demonstration Effect

the determinant of consumption is the relative income and the relative income theory stresses that people and households or all members of the community tend to follow the level of consumption of their fellow citizens or within the specific society. This is known as the demonstration effect or Duesenberry effect.

There are two main implications in this effect

1) The average propensity to consume does not fall because as the income of all members of the society increases with the same percentage the relative income distribution would not change and consequently the consumption expenses from income which is dependent upon the relation income would stay constant

2) if the income of a household is considered as relatively low then its individuals would spend more of their income due to the demonstration effect, on the contrary, if the income of a household is considered as relatively higher then its individuals would spend less of their income due to the absence of demonstration effect

For instance, new studies have shown that if the monthly income of a household in an urban area is Rs.10000 then they would consume a higher percentage of their income compared to a household those who live in rural areas. The propensity to consume is higher in the household of urban areas because of the demonstration effect because households with higher incomes live over there and their higher standard of living lures the household with low income to spend more of their incomes.


Ratchet effect

The relative income ( Theories of Consumption ) theory of Duesenberry states that when the income of household individuals decreases due to a recession or depressing period in the economy their spending does not that much this is known as the ratchet effect. The reason behind this effect is that people tend to uphold the way of consuming their income as before because they might not want to make it obvious to others that they could not manage to preserve their standard of living or because they become used to of the patterns of consuming their income and they prefer to decrease their savings instead of changing their consuming patterns.

Franco Modigliani and the life cycle hypothesis

According to this hypothesis, ( Theories of Consumption ) assumed that people stop working around the age of 65, and obviously their incomes fall however they do not expect a major decline in their way of living according to their consumption. To continue their higher standard of living a=even after their retirement people need to save during their job-time. For example, if a consumer, Mr. Koko expects to live for more “T” years and he has wealth/capital of “W” and he supposes that he would earn income “Y” until his retirement “R” years from now onwards. We would be assuming that the interest rate is zero because otherwise, we would need to consider the interest rate as well. The total funds of the consumer consist of his preliminary wealth W and his income during his lifetime Y i.e.    R x Y. The lifetime possessions of the consumer could be split in between the rest of the years of his life T. Assuming that he wants to gain the plain likely consumption path during his life. Consequently, he divides the whole of the W + RY equally between the T years, and per year the consumption is as follows C = (W + RY)/T. The function of the consumption of Mr. Koko can be written as C = (1/T)W + (R/T)Y. For instance, Mr. Koko assumes that he would live for 60 years more and assumes that he would work for 40 years more than T = 60 and R = 40, then his function of consumption is C = 0.017W + 0.7Y. the equation shows that consumption is dependent upon two factors that are income and wealth. One additional dollar of income ($1) increases the consumption of one year by $0.70 per year whereas one additional dollar ($1) of wealth increases the consumption by $0.017 per year in this case. And if all of the individuals of the society would start planning like this then the aggregate consumption function of all of the individuals would be similar to Mr. Koko’s aggregate consumption function. Furthermore, the aggregate consumption function is also dependent upon two factors wealth and income. The aggregate consumption function of the economy is              C = aW + bY,

When a = the marginal propensity to spend from wealth

When b = the marginal propensity to spend from the income


Life-cycle hypothesis


Implications of the Franco Modigliani and the life cycle hypothesis

Figure 2 shows the relationship between the consumption and the income as foreseen by the lie cycle model. For any amount of wealth W, the model explains a predictable consumption function as shown in figure 2. Moreover, the intercept of the function of the consumption shows the case that if the incomes ever fall to zero what would happen with the consumption is shown in figure 2. The intercept in this case is the aW and therefore it depends on the wealth level. The life cycle model consumption of the behavior of consumer suggests that the average propensity to consume (APC) is C/Y = a(W/Y) + b. since the wealth varies non uniformly with the income from each individual to other individual or from one year to another. Studies from a short span of time have shown that higher income is likely to have a lower average propensity to consume (APC). However, over the long time span, the wealth and the income raise together whose outcome is that the ratio of the W/Y would be constant and hence, which causes the average propensity to consume (APC) to be constant

Milton Friedman and the permanent income hypothesis

Milton Friedman stated that the current income can be regarded as Y the total of two parts of income Yp as permanent income and Yt as transitory income i.e. Y = Yp + Yt. the permanent income continues during the work-time of an individual whereas the transitory income is unexpected income and it can be in form of a prize or bonus. Moreover, permanent income is considered as the average income of an individual as compared to the transitory income which is considered as a casual fluctuation from that particular average income.

For example, Karen who is an MBBS doctor managed to earn more in the current year than Koko who is a college dropout. Higher-income of Karen is due to her high permanent income because of her higher education and her permanent income would remain.

In the above example, it is shown that higher education is basically a source of permanent income.

Mojo who is a wheat grower managed to earn more in the current year due to good days of sunshine in his area rather than Cabot, who is also a wheat grower because of the rainier days in his area. Mojo could earn more due to the transitory income because the weather is unpredictable and could be different next year.

In the above example, the change in the weather is a source of transitory income.

( Theories of Consumption ) In this theory, we assume that other things are constant and we deal only with the transitory and permanent income. The theorist suggested that the consumption of an individual is dependent upon the permanent income because most of the people usually save the money they get from the transitory income. For example, if an individual gets raise in his permanent income Rs. 5000 then the consumption of that individual would increase by almost the same amount. Whereas if an individual earned a bonus of Rs 10000 then he would divide that money over the course of his lifetime. In this case, we suppose that the interest rate s zero and that the remaining duration of his life is 50 years. The consumption of an individual would increase Rs. 200 every year. Therefore, it shows that individuals spend their permanent income however they prefer to save their transitory income. Milton Friedman determined that the function of pf consumption can be written as

C = a Yp, where a is a constant which measures the consumed part of the permanent income

And as shown by the above equation the hypothesis of permanent income is directly proportional to the consumption

Implications of Milton Friedman and the permanent income hypothesis

As stated, by the ( Theories of Consumption ) hypothesis of permanent income the consumption of an individual depends on the permanent income Yp. And to obtain the APC for this function we divide both of the sides of the function by Y to obtain APC = C/Y = aYp /Y. According to recent research, families who have high-income sources usually have a low average propensity to consume. However, the random fluctuations in the income are considered as transitory income

(“3 Important Theories of Consumption (With Diagram),” n.d.)

Written by:

Noor Mubeen Aslam Sipra

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