Monday, August 24, 2009

Relative Income Hypothesis

The relative income hypothesis was first introduced by Dorothy Brady and Rose Friedman. It stated that the consumption expenditure does not depend on absolute level of income but instead on the relative level of income. Dussenburry lent it empirical and psychological support.

According to Dussenberry there is strong tendency for the people to emulate and initiate the consumption pattern of their neighbours. This is the ‘demonstration effect’ i.e. relative income affecting consumption. The Relative Income theory tells us that the level of consumption spending is determined by the households level of current income relative to the highest level of income earned previously people are the reluctant to revert to the previous low level of consumption. This is the ‘Rachet Effect’.

The Relative Income Theory states that if the current and peak incomes grow together changes in consumption are always proportional to change in income. That is, when the current income rises proportionally with peak income, the average propensity to consume (APC) remains constant.

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