Absolute Income Hypothesis

The absolute income hypothesis (AIH) is a theory of consumption that proposes that an individual’s current consumption depends on their current level of income, rather than their income relative to others in society. In other words, the AIH suggests that individuals consume based on their absolute level of income, rather than their relative income or social position.

The AIH was first proposed by economist John Maynard Keynes in the 1930s, as part of his broader work on macroeconomic theory and policy. Keynes argued that consumption was a key driver of economic activity, and that understanding the factors that influenced consumption was crucial for understanding economic growth and stability.

According to the AIH, an individual’s consumption can be described by the following equation:

C = a + bY

Where C is consumption spending, Y is income, a is autonomous consumption (consumption spending that does not depend on income), and b is the marginal propensity to consume (MPC), which represents the fraction of additional income that is spent on consumption.

The AIH suggests that individuals consume based on their level of income, as captured by the Y variable in the equation. The autonomous consumption component (a) represents spending that is independent of income, such as spending on basic necessities like food and shelter.

The MPC (b) captures the relationship between changes in income and changes in consumption spending. For example, if the MPC is 0.6, this means that for every additional dollar of income, 60 cents will be spent on consumption, while 40 cents will be saved or invested.

The AIH assumes that the MPC is constant across different income levels, meaning that individuals with higher incomes will have a higher level of autonomous consumption, but will still have the same MPC as those with lower incomes.

One of the key implications of the AIH is that changes in income have a direct impact on consumption spending, regardless of the individual’s relative income level or social position. For example, if the government implements a tax cut that increases disposable income for all individuals, this will lead to an increase in consumption spending across the board, as individuals will have more money to spend on goods and services.

Similarly, if there is a recession or economic downturn that leads to a decline in income for individuals, this will lead to a decrease in consumption spending as individuals cut back on their spending to adjust to the lower level of income.

The AIH has been subject to criticism and modification over the years, as researchers have recognized that consumption decisions may be influenced by factors beyond income alone. For example, social and cultural factors may play a role in shaping individual consumption patterns, and the timing and uncertainty of income may also be important.

In addition, researchers have recognized that the MPC may not be constant across different income levels, as individuals with higher incomes may have a lower MPC due to their ability to save and invest more of their income. This has led to the development of alternative theories of consumption, such as the relative income hypothesis and the permanent income hypothesis.

Despite these limitations, the AIH remains an important concept in economics for understanding the relationship between income and consumption, and the ways in which changes in income can impact economic activity and growth. By understanding the factors that influence consumption decisions, policymakers can design policies that support economic stability and promote sustainable growth.

Absolute Income Hypothesis example

To illustrate the absolute income hypothesis, let’s consider the following hypothetical example:

Suppose that an individual has an autonomous consumption level of $1,000, and a marginal propensity to consume (MPC) of 0.75. This means that for every additional dollar of income, the individual will spend 75 cents on consumption and save 25 cents.

If the individual’s income is $10,000, their consumption spending can be calculated as follows:

C = a + bY

C = $1,000 + 0.75($10,000)

C = $8,500

So, with an income of $10,000, the individual’s consumption spending would be $8,500.

Now suppose that the individual receives a raise and their income increases to $12,000. According to the absolute income hypothesis, the individual’s consumption spending would increase in proportion to their increase in income. The new level of consumption spending can be calculated as follows:

C = a + bY

C = $1,000 + 0.75($12,000)

C = $10,000

So, with an income of $12,000, the individual’s consumption spending would increase to $10,000.

Alternatively, if the individual’s income were to decrease to $8,000, their consumption spending would decrease proportionally, as follows:

C = a + bY

C = $1,000 + 0.75($8,000)

C = $7,000

So, with an income of $8,000, the individual’s consumption spending would decrease to $7,000.

This example illustrates the basic principle of the absolute income hypothesis: that consumption spending is directly proportional to income, regardless of the individual’s relative income level or social position. While the MPC may vary from individual to individual, the AIH assumes that the MPC is constant across different income levels for a given individual.