by The Relative Income Hypothesis (RIH) is a concept in economics that explains how people’s consumption decisions are influenced by their relative income rather than absolute income. The hypothesis proposes that individuals’ consumption patterns are determined not by the level of their own income but by their income relative to the income of others in their social group or community. This theory is based on the idea that people care about their relative status and social position and will make consumption decisions accordingly.
The Relative Income Hypothesis was first proposed by economist James Duesenberry in his 1949 paper, “Income, Saving, and the Theory of Consumer Behavior”. Duesenberry’s theory was later developed and expanded upon by other economists, including Andrew Abel and Olivier Blanchard.
At its core, the Relative Income Hypothesis argues that people’s consumption decisions are based on two primary factors: their absolute income and their relative income. Absolute income refers to the total amount of income an individual earns, while relative income refers to an individual’s income relative to the income of others in their social group or community.
According to the RIH, an increase in an individual’s absolute income will lead to an increase in their consumption. However, the theory also argues that an increase in an individual’s relative income will lead to an even greater increase in their consumption. This is because people care about their social position and status and will therefore adjust their consumption to match that of their peers or social group.
The Relative Income Hypothesis suggests that individuals will compare their income and consumption patterns to those of others in their social group. This comparison process leads to a phenomenon known as “keeping up with the Joneses,” where people will increase their consumption in order to maintain or improve their relative social status. This can lead to a cycle of consumption where individuals constantly strive to match or exceed the consumption patterns of those around them.
However, the Relative Income Hypothesis also suggests that people are more likely to be influenced by the consumption patterns of those closest to them, such as family members or neighbors, rather than the consumption patterns of society as a whole. This is because people tend to compare themselves to those with whom they have the most frequent contact and interaction.
The Relative Income Hypothesis has a number of implications for economic theory and policy. For example, the theory suggests that inequality in society can lead to higher levels of consumption overall, as people try to maintain or improve their relative position. This can have negative consequences for the environment and for social cohesion, as well as for individual well-being if people feel pressure to consume beyond their means.
The theory also has implications for taxation and redistribution policies. According to the RIH, if people are primarily motivated by relative income, then policies that focus solely on raising absolute income levels may not be effective in reducing poverty or inequality. Instead, policies that address relative income, such as progressive taxation or income redistribution, may be more effective in promoting greater equality and well-being.
Additionally, the Relative Income Hypothesis can help explain certain consumption patterns and trends, such as the rise of conspicuous consumption and the increased importance of status symbols in consumer behavior. It can also shed light on why people may be willing to pay more for goods and services that are seen as exclusive or prestigious.
Critics of the Relative Income Hypothesis argue that it may oversimplify the complexity of human behavior and decision-making. They argue that people’s consumption decisions are influenced by a wide range of factors beyond just relative income, including personal preferences, cultural norms, and individual circumstances.
Example:
To provide an example of the Relative Income Hypothesis, consider two individuals, A and B, who both earn $50,000 per year. However, A’s social group consists of individuals who earn an average of $40,000 per year, while B’s social group consists of individuals who earn an average of $60,000 per year.
According to the Relative Income Hypothesis, A and B will have different consumption patterns despite having the same absolute income. A is likely to consume less than B because their income is higher relative to their social group. On the other hand, B is likely to consume more than A because their income is lower relative to their social group. In this way, relative income influences consumption decisions even when absolute income is the same.
This example illustrates how the Relative Income Hypothesis can explain consumption patterns based on relative income, rather than absolute income alone. It also demonstrates the importance of social comparisons and the impact they can have on consumption decisions.
