INTRODUCTION

• Consumption function plays a crucial role in the theory of income and employment, as explained by Keynes.
• Keynes identified several subjective and objective factors that determine consumption in a society, with the current level of income being the most important determinant.
• Since Keynes emphasizes the absolute size of income as the key factor for determining consumption, his theory is called the absolute income theory.
• Keynes’s psychological law of consumption suggests that as income increases, consumption increases, but not by the same amount. In other words, the marginal propensity to consume (MPC) is less than one.
• After Keynes, several alternative theories of consumer behavior have been proposed.
• Duesenberry proposed the Relative Income Theory of Consumption, stating that consumption depends on an individual’s income relative to others, not just on their own absolute income.
• Modigliani put forward the life cycle hypothesis, which states that individuals plan their consumption based on their lifetime income expectations, not just their current income.
• Friedman developed the permanent income hypothesis, which argues that consumption depends on permanent income rather than current income levels.
• Kuznets, a Nobel Prize-winning economist, found a puzzle regarding consumption behavior. He observed that, contrary to Keynes’s theory that the average propensity to consume (APC) falls as income rises, the APC remained constant despite significant increases in income in the USA economy.
• This puzzle raised questions about why APC remained stable despite rising income, which is a key issue in consumption theory.
• Modern theories, including Duesenberry’s relative income theory, the life cycle hypothesis, and Friedman’s permanent income hypothesis, attempt to resolve this puzzle.

RELATIVE INCOME THEORY OF CONSUMPTION

• J.S. Duesenberry, an American economist, proposed a theory of consumer behavior that emphasizes relative incomerather than absolute income as a determinant of consumption.
• Duesenberry’s theory is a departure from Keynes’s consumption theory, as it suggests that an individual’s consumption does not depend on their current income, but on a previously reached income level.
• According to Duesenberry’s relative income hypothesis, consumption is determined by an individual’s relative position in society’s income distribution, not just their absolute income.
• If the incomes of all individuals in society increase by the same percentage, their relative income remains unchanged, and thus, they will spend the same proportion of their income on consumption, keeping the average propensity to consume (APC) constant.
• Kuznets’ empirical studies suggest that the APC remains constant over time, which aligns with Duesenberry’s hypothesis.
• As the income of a society increases, individuals in low-income brackets will not increase their savings proportionally compared to those with higher incomes, because their relative income has not changed.
• Duesenberry’s relative income theory suggests that as income increases, consumption function shifts upward, not along the same curve, which would otherwise cause a decline in the APC.
• In Figure 7.1, as income rises, consumption will increase proportionally, maintaining the same APC.

• For example, when Family A’s income increases, their consumption will not rise as much as their new income level but will instead rise proportionally, maintaining the APC.
• Similarly, for Family B, as income rises, the APC remains constant as consumption increases proportionally.
• The aggregate consumption in the community will remain constant as a proportion of income, even though both absolute consumption and savings increase with rising incomes.
• The Demonstration Effect (or Duesenberry Effect) implies that people try to imitate the consumption levels of others, influencing their own consumption patterns based on their relative position in society.
• As a result of the Demonstration Effect, families with the same income may spend differently depending on whether they live in a high-income or low-income community.
• For example, families in urban areas with the same income as rural families may spend more, influenced by the higher consumption levels they observe in urban communities.
• The Ratchet Effect suggests that when individuals’ income falls, they will not reduce their consumption by the same amount. Instead, they will try to maintain their previous consumption levels, often by saving less.
• This phenomenon is illustrated in Figure 7.2, where a recession reduces income, but consumption does not fall significantly, as people try to maintain their previous consumption levels by reducing savings.

• The Ratchet Effect implies that the average propensity to consume (APC) does not decline as much as income does, since people maintain their previous consumption levels by reducing savings.
• Aggregate consumption function is flatter than expected from family budget studies because the Demonstration and Ratchet Effects mitigate the fluctuations in consumption with respect to income changes.
• Duesenberry’s theory suggests that the short-run aggregate consumption function is linear, not curved, because the APC does not change significantly with income increases or decreases due to the operation of the Demonstration and Ratchet Effects.
• Duesenberry’s theory assumes that relative income distribution remains stable in the short run, which aligns with real-world observations where changes in income distribution are slow.
• Therefore, Duesenberry’s theory offers a convincing explanation for the linear aggregate consumption function in the short run, explaining the Demonstration and Ratchet Effects.