RELATIVE INCOME HYPOTHESIS

Relative income hypothesis states that the satisfaction (or utility) an individual derives from a given
consumption level depends on its relative magnitude in the society (e.g., relative to the average
consumption) rather than its absolute level. It is based on a postulate that has long been acknowledged
by psychologists and sociologists, namely that individuals care about status. In economics, relative
income hypothesis is attributed to James Duesenberry, who investigated the implications of this idea for
consumption behavior in his 1949 book titled Income, Saving and the Theory of Consumer Behavior.

At the time when Duesenberry wrote his book the dominant theory of consumption was the one
developed by the English economist John Maynard Keynes, which was based on the hypothesis that
individuals consume a decreasing, and save an increasing, percentage of their income as their income
increases. This was indeed the pattern observed in cross-sectional consumption data: At a given point in
time the rich in the population saved a higher fraction of their income than the poor did. However,
Keynesian theory was contradicted by another empirical regularity: Aggregate saving rate did not grow
over time as aggregate income grew. Duesenberry argued that relative income hypothesis could account
for both the cross-sectional and time series evidence.

Duesenberry claimed that an individual’s utility index depended on the ratio of his or her consumption
to a weighted average of the consumption of the others. From this he drew two conclusions: (1)
aggregate saving rate is independent of aggregate income, which is consistent with the time series
evidence; and (2) the propensity to save of an individual is an increasing function of his or her percentile
position in the income distribution, which is consistent with the cross-sectional evidence.

Despite its intuitive and empirical appeal Duesenberry’s theory has not found wide acceptance and has
been dominated by the life-cycle/permanent-income hypothesis of Franco Modigliani and Richard
Brumberg (published in 1954) and Milton Friedman (1957). These closely related theories implied that
consumption is an increasing function of the expected lifetime resources of an individual and could
account for both the cross-sectional and time series evidence previously mentioned. However, starting
with the 1970s, inability of these theories to explain some other puzzling empirical observations as well
as the increasing evidence that people indeed seem to care about relative income have generated
renewed interest in relative income hypothesis.

The first piece of evidence was presented in 1974 by Richard Easterlin, who found that self-reported
happiness of individuals (i.e., subjective well-being) varies directly INTERNATIONAL ENCYCLOPEDIA OF
THE SOCIAL SCIENCES, 2ND EDITION 153 Relative Income Hypothesis with income at a given point in
time but average wellbeing tends to be highly stable over time despite tremendous income growth.
Easterlin argued that these patterns are consistent with the claim that an individual’s wellbeing depends
mostly on relative income rather than absolute income. Subsequent research, such as that published by
Andrew Oswald in 1997, has accumulated abundant evidence in support of this claim.

Relative income hypothesis has also found some corroboration from indirect macroeconomic evidence.
One of these is the observation that higher growth rates lead to higher saving rates, which is
inconsistent with the lifecycle/permanent-income theory since the lifetime resources of an individual
increases as growth rate increases. The work of Christopher Carroll, Jody Overland, and David N. Weil
explains this observation with a growth model in which preferences depend negatively on the past
consumption of the individual or on the past average consumption in the economy that is under the
relative income hypothesis.

Another empirical observation that has been problematic for the life-cycle/permanent-income theory is
the equity premium puzzle, which states that the observed difference between the return on equity and
the return on riskless assets is too large to be explained by a plausible specification of the theory.
Introducing past average consumption into the preferences accounts for this observation much better.

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 Koçkesen,
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.

What Is the Permanent Income Hypothesis?

The permanent income hypothesis is a theory of consumer spending stating that people will
spend money at a level consistent with their expected long-term average income. The level of
expected long-term income then becomes thought of as the level of “permanent” income that
can be safely spent. A worker will save only if his or her current income is higher than the
anticipated level of permanent income, in order to guard against future declines in income.

Understanding the Permanent Income Hypothesis

The permanent income hypothesis was formulated by the Nobel Prize-winning economist Milton
Friedman in 1957. The hypothesis implies that changes in consumption behavior are not
predictable because they are based on individual expectations. This has broad implications
concerning economic policy.

 
The permanent income hypothesis is a theory of consumer spending stating that people will
spend money at a level consistent with their expected long-term average income.
Under this theory, even if economic policies are successful in increasing income in the
economy, the policies may not kick off a multiplier effect from increased consumer spending.
Rather, the theory predicts there will not be an uptick in consumer spending until workers reform
expectations about their future incomes.