2. The Absolute Income
Hypothesis
John Maynard Keynes
The Relative Income
Hypothesis
Prof Duessenberry
The Permanent Income
Hypothesis
Milton Friedman
The Life Cycle Income
Hypothesis
Albert Ando and
Franco Modigliani
3. Absolute Income
Hypothesis
Postulate:
Based on the fundamental psychological
law of consumption that states that as
income increases, consumption increases
but not as much as the increase in income.
Properties of Keynesian Consumption
Function:
1. The real consumption expenditure is a
positive function of real current
disposable income.
2. The MPC lies between 0 to 1
3. The MPC is less than APC
4. MPC declines as the income increases.
Drawbacks
1. Theory is based more on
introspection rather than
observed facts.
2. Early empirical studies have
supported only the 1st and 3rd
properties . The 2nd and 4th
properties have failed for the
empirical tests.
3. Kuznet’s theory post the war,
from 1869 to 1929 disclosed that
MPC remained constant over the
period
4. Relative Income
Hypothesis
Postulate:
States that the proportion of the
income consumed by a
household depends on the level
of its income in relation to the
households with which it
identifies itself, not on its
absolute income.
The theory links consumption
level of a household with the
income and expenditure level
of the households of the
comparable groups.
Properties of Consumption:
If income of all households belonging to the
group including H person increases by the same rate,
then Consumption of all households of the group
increases by same rate and vice versa.
If H remains on same scale of relative income and
its absolute income increases, then its absolute C &S
increases but MPC remains the same as it was
before the rise in income.
If H remains on same scale of relative income and
the income of other households in the group
increases, MPC of H with constant income rises
If H moves from a lower income group to a higher
income group then its MPC decreses
5. RATCHET EFFECT
While the Absolute Income Hypothesis holds
that consumption decreases in proportion to
decrease in income, relative income hypothesis
states that the consumption does not decrease
in proportion to decrease in income because of
RATCHET EFFECT
Ratchet effect arises due to households
resistance against fall in consumption
following a decrease in income. Duessenberry
says as absolute income decreases, households
do not cut their consumption in proportion to
the fall in income because they get used to a
certain standard of living.
Shortcomings of RIH:
•The theory states that an
upward change in income
and consumption is always
proportional irrespective of
whether the change is small
or large.
•Consumptions standards
are irreversible , this is a
short run phenomenon but
not a long rum
phenomenon.
6. Permanent Income
Hypothesis
Postulate:
The level of current consumption depends
on consumer’s permanent income, not on
the current income.
Definition of Permanent Income:
Permanent income is defined as the mean of all
the incomes anticipated by the households in the
Long run. Permanent includes income from
both human wealth and non human wealth.
Transitory Income
Income from special bonus, wage increments,
dearness allowances, lottery wins, losses from
lottery, nonpayment of sickness leave,
temporary loss of job, non payment of wages
due to labour strikes,but in LR the losses and
gains are balanced
Permanent Income
Human Wealth
(income from
human capital
like training,
education, skill,
intelligence etc)
Non Human
wealth (income
from assets as
money, stock,
bonds, real
estate, consumer
durables)
7. Permanent consumption (CP) = K YP
where k is the proportion of income consumed and Yp is the Permanent
income
Ym = Yp + Ytr
Where Ym is measured income, Yp is Permanent Income and Ytr is transitory
income.
Cm = Cp + Ctr
Where Cm is measured consumption, Cp is Permanent consumption and Ctr is
transitory consumption
R (Yp & Ytr )=0
R (Cp & Ctr )=0
R (Ytr & Ctr )=0
8. Drawbacks of PIH
1)Ignores correlation between temporary income and
consumption which can significantly affect individual’s
consumption pattern both in long and short run.
2)Average consumption of different social groups is not same.
Rich individuals will have lower APC compared to poor
individuals.
3)No clear distinction between human and non-human
wealth.
