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The relative income hypothesis of James Duesenberry is based on the rejection of the two fundamental assumptions of the consumption theory of Keynes. Duesenberry states that

(1) every individual’s consumption behaviour is not independent but interdependent of the behaviour of every other individual

 (2) that consumption relations are irreversible and not reversible in time.

In formulating his theory of the consumption function, Duesenberry writes: “A real understanding of the problem of consumer behaviour must begin with a full recongnition of the social character of consumption patterns.” By the “social character of consumption paterns” he means the tendency in human beings not only “to keep up with the Joneses” but also to surpass the Joneses. Joneses refers to rich neighbours. In other words, the tendency is to strive constantly toward a higher consumption level and to emulate the consumption patterns of one’s rich neighbours and associates. Thus consumers’ preferences are interdependent. It is, however, differences in relative incomes that determine the consumption expenditures in a community. A rich person will have a lower APC  because he will need a smaller portion of his income to maintain his consumption pattern. On the other hand, a relatively poor man will have a higher APC because he tries to keep up with the consumption standards of his neighbours or associates. This provides the explanation of the constancy of the long-run APC because lower and higher APCs would balance out in the aggregate. Thus even if the absolute size of income in a country increases, the APC for the economy as a whole at the higher absolute level of income would be constant. But when income decreases, consumption does not fall in the same proportion because of the Ratchet Effect.

The Ratchet Effect

The second part of the Duesenberry theory is the “past peak of income” hypothesis which explains the short-run fluctuations in the consumption function and refutes the Keynesian assumption that consumption relations are reversible. The hypothesis states that during a period of prosperity, consumption will increase and gradually adjust itself to a higher level. Once people reach a particular peak income level and become accustomed to this standard of living, they are not prepared to reduce their consumption pattern during a recession. As income falls, consumption declines but proportionately less than the decrease in income because the consumer dissaves to sustain consumption. On the other hand, when income increases during the recovery period, consumption rises gradually with a rapid increase in saving. Economists call this the Ratchet Effect.

Duesenberry combines his two related hypothesis in the following form

where C and Y are consumption and income respectively, t refers to the current period and the subscript (o) refers to the previous peak, a is a constant relating to the positive autonomous consumption and c is the consumption function.

In this equation, the consumption-income ratio in the current period (Ct /Yt ) is regarded as function of Yt /Yo, that is, the ratio of current income to the previous peak income. If this ratio is constant, as in periods of steadily rising income, the current consumption income ratio is constant. During recession when current income (Yt ) falls below the previous peak income (YO), the current consumption income ratio (Ct /Yt ) will increase.

FIGURE 1

The relative income hypothesis is explained graphically in Fig. 1 where CL is the long-run consumption function and CS1 and CS2 are the short- run consumption functions. Suppose income is at the peak level of OY1 where E1Y1 is consumption . Now income falls to OY0. Since people are used to the standard of living at the OY1 level of income, they will not reduce their consumption to E0Y0 level, but reduce it as little as possible by reducing their current saving. Thus they move backward along the CS1 curve to point C1 and be at C1Y0 level of consumption. When the period of recovery starts, income rises to the previous peak level of OY1. But consumption increases slowly from C1 to E1 along the CS1 curve because consumers will just restore their previous level of savings. If income continues to increase to OY2 level, consumers will move upward along the CL curve from E1 to E2 on the new short-run consumption function CS2. If another recession occurs at OY2 level of income, consumption will decline along the CS2 consumption function toward C2 point and income will be reduced to OY1 level. But during recovery over the long-run, consumption will rise along the steeper CL path till it reaches the short-run consumption function CS2. This is because when income increases beyond its present level OY1, the APC becomes constant over the long-run. The short-run consumption function shifts upward from Cs1 to Cs2 but consumers move along the CL curve from E1 to E2. But when income falls, consumers move backward from E2 to C2 on the Cs2 curve. These upward and downward movements from C1 and C2 points along the CL curve give the appearance of a ratchet. This is the rachet effect. The short-run consumption function ratchets upward when income increases in the long run but it does not shift down to the earlier level when income declines. Thus the ratchet effect will develop whenever there is a cyclical decline or recovery in income.

Criticisms

Although the Duesenberry theory reconciles the apparent contradictions between budget studies and short-term and long-term time series studies, yet it is not without its deficiencies.

1. No Proportional Increase in Consumption

The relative income hypothesis assumes a proportional increase in income and consumption. But increases in income along the full employment level do not always lead to proportional increases in the consumption.

2. No Direct Relation between Consumption and Income

This hypothesis assumes the relation between consumption and income to be direct. But this has not been borne out by experience. Recessions do not always lead to decline in consumption, as was the case during the recessions of 1948-49 and 1974-75.

3. Distribution of Income not Unchanged

This theory is based on the assumption that the distribution of income remains almost unchanged withthe change in the aggregate level of income. If with increases in income, a redistribution occurs towards greater equality, the APC of all persons belonging to the relatively poor and relatively rich families will tend to be reduced. Thus the consumption function will not shift upward from CS1 to CS2 when income increases.

4. Reversible Consumer Behaviour

According to Micheal Evants, “The consumer behaviour is slowly reversible over time, instead of being truly irreversible. Then previous peak income would have less effect on current consumption, the greater the elapsed time from the last peak.” Even if we know how a consumer spent his previous peak income, it is not possible to know how he would spend it now.

5. Neglects Other Factors

This hypothesis is based on the assumption that changes in consumer’s expenditure are related to his previous peak income. The theory is weak in that it neglects other factors that influence consumer spending such as asset holdings, urbanisation, changes in age- composition, the appearance of new consumer goods, etc.

6. Consumer Preferences do not Depend on Others

Another unrealistic assumption of the theory is that consumer preferences are interdependent whereby a consumer’s expenditure is related to the consumption patterns of his rich neighbour. But this may not always be true. George Katona’s empirical study has revealed that expectations and attitudes play an important role in consumer spending. According to him, income expectations based on levels of aspirations and the attitudes toward asset holdings affect consumer spending behaviour more than the demonstration effect.

7. Reverse Lightning Bolt Effect

Smith and Jackson have criticised Duesenbery’s empirical evidence that the recovery in income after recession is not caused by ratchet effect. Rather, the consumption experience of consumer is similar to the reverse lightning bolt effect. That is why the consumer gradually increases his consumption due to his inconsistent habit stability with the increase in his income after recession.

FIGURE 2

This is shown is Fig.2 where the levels of consumption with the increments in income have been shown by arrows as reverse lightning bolt takes place.

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