THEORIES OF CONSUMPTION

The Absolute Income Hypothesis by John Meynard Keynes

The Keynesian consumption theory is based on, what he calls, “a fundamental psychological law.” This
law, which depends greatly on a priori knowledge of human nature and from the detailed facts of
experience, states that men are disposed, as a rule and on average, to increase their consumption as their
income increases, but not by as much as their increase in income. `In technical terms, this law means that

dC
MPC ( ¿ is “positive and less than unity”. According to Keynes, households decide their current
dy
consumption expenditure on the basis of their current income. Based on this law, the absolute-income
theory of consumption hypothesizes that current consumption expenditure depends on current and
absolute level of income . That is

C = ƒ (Y)

Where C = current consumption and Y = current income

This Keynesian theory of consumption can be summarized into four propositions

1. The current consumption expenditure is positive function of the current (disposable) income.
Keynes thought that income is the primary determinant of consumption and that the interest rate
does not have an important role
2. The marginal propensity to consume—the amount consumed out of an additional dollar of
income—is between zero and one.
3. The MPC is less than average propensity to consume (APC).
4. Keynes posited that the ratio of consumption to income, that is, the APC, falls as income rises.
 CRITICISMS OF ABSOLUTE INCOME HYPOTHESIS
1. It is based more on introspection than on observed facts. The theory is conjectural and not
supported by empirical data.
2. Simon Kuznets constructed new aggregate data on consumption and income from 1869.
1929. Kuznets assembled these data in the 1940s and discovered that APC was remarkably
stable from decade to decade, despite large increases in income over the period he studied.
3. In fact, still based on Kuznets’ study, MPC = APC ≈ 0.9

In summary, Keynes’s conjectures hold up well in the studies of household data and in
the studies of short time-series but fail when long time-series were examined.
Hence, the Keynesian theory of consumption is treated as a short-run theory.
THE RELATIVE INCOME HYPOTHESIS BY DUESENBERRY
Because Keynes’ consumption theory could not be substantiated by empirical data,
after World War II, several economists attempted to develop a theory based on
empirical facts. By using data of 1940s, he propounded the relative income
hypothesis.
The relative income hypothesis states that the proportion of income consumed by a
household depends on the level of its income in relation to the households with
which it identifies itsel not on its absolute income. In other words, the level and
pattern of the consumption of a household is determined by the consumption level
and pattern of the households with which it lives or of those with whom it wishes to
keep up.
We can summarize this theory by four propositions.
Assuming a household H from a group of households with more or less of the same
level of income :
1. If consumption level of all the households belonging to the group increases
by about the same rate, then the consumption level of all households of the
group, including household H, goes up at the same rate and vice versa. That
 is, MPC remains the same for all the households if their income changes by
the same amount.
2. If household H remains at the same scale of relative income and its absolute
income rises, then its absolute consumption and savings rise, but its MPC
remains the same as it was before the rise in its income.
3. If household H remains on the same scale of the relative income (with income
constant) and the income of other households of the group increases, then
MPC of household H with constant income increases.
4. If household H moves up from a lower income-group to a higher income
group then its APC decreases.
The above propositions are due to the following reasons :
a. People prefer high quality goods to low quality ones. This he referred to as the
“demonstration effect”;
b. A person’s consumption habits are affected by the consumption habits of those with
whom he hobnobs; and
c. It is harder for a family (household) to reduce expenditures than to refrain from making
them in the first place.

While absolute income hypothesis holds that consumption decreases in proportion to decrease in income,
the relative income hypothesis holds that consumption does not decrease in proportion to decrease in
income because of what we call the Ratchet Effect. Ratchet effect arises due to household’s resistance
against the fall in consumption following a decrease in income.
Consider the diagram below :
Assume at point R1, there was a recession, and consequently, reduces consumption. As said earlier,
households will not reduce consumption proportionately; rather they will reduce their saving in
order to maintain their consumption pattern. Thus APC rises, and so, they move along C1R1 (the
short-run consumption). As recession fades out, income rises and consumers move upwards
along R1C1 back towards R1 making APC to fall and APS to rise. Another increase in income will
force the household back to the long-run line and move to a point like R2. When recession sets
in, he moves along C2R2 (short-run phenomenon) and as the economy recovers, he moves back to
R2. The upturn and downturn (cyclical) fluctuation in the economy makes a consumer to be
adjusting his consumption in order to keep up with the Joneses. The upward and backward
movement to the long-run consumption function produce ratchet effect or the zig-zag
movement.

Criticsm of Relative Income Hypothesis

a. Increases in income along the full employment level do not always lead to proportional
increases in the consumptions.
b. Recessions do not always lead to decline in consumption
c. The distribution of income is not always constant
d. Consumer behaviour is not rigidly irreversible, it is slowly reversible
e. The theory did not take into consideration other drivers of consumption