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Relative income hypothesis

The Relative Income Hypothesis (RIH) is an economic theory formulated by James S. Duesenberry in 1949, positing that an individual's utility from consumption and their saving decisions depend primarily on their income and consumption relative to others in their social reference group, rather than on absolute levels of income.^[1] As Duesenberry stated, "the utility index is a function of relative rather than absolute consumption expenditure."^[1] This framework explains why aggregate savings ratios remain stable over time despite rising absolute incomes, as consumption adjusts to maintain social standing within income distributions.^[2] Duesenberry developed the RIH to address a key puzzle in consumption economics: the inconsistency between cross-sectional data, which show savings rates increasing with income levels, and time-series data, which indicate a roughly constant average propensity to save across economic expansions.^[1] He argued that preferences are interdependent, with consumption influenced by social and psychological factors rather than isolated utility maximization.^[1] Central to the theory are two mechanisms: the demonstration effect, where individuals emulate the consumption patterns of higher-income peers through social interactions, leading to upward pressure on spending; and the ratchet effect, which describes the irreversibility of consumption habits, such that spending does not decline proportionally during income downturns after previous peaks.^[1] Mathematically, Duesenberry formalized this by suggesting that for a given relative income distribution, the savings percentage is "a unique, invariant, and increasing function of [a family's] percentile position in the income distribution," independent of absolute income.^[1]^[2] The RIH has influenced subsequent theories of consumer behavior, including permanent income and life-cycle hypotheses, by highlighting social comparisons and habit persistence.^[3] Empirical studies continue to find support for its core ideas, such as in analyses of consumption in developing economies where relative income drives spending patterns more than absolute gains.^[3] For instance, evidence from Nepal (1974–2019) confirms the ratchet and demonstration effects through cointegrated time-series models, with short-run adjustments aligning consumption to relative positions.^[3] These insights underscore the hypothesis's relevance for understanding inequality, savings trends, and policy responses to economic fluctuations.

Historical Development

Origins in Economic Thought

The concept of consumption being influenced by social comparisons and status rather than solely absolute economic needs emerged in economic thought well before the mid-20th century. Thorstein Veblen, in his seminal 1899 work The Theory of the Leisure Class, introduced the idea of "conspicuous consumption," where individuals engage in lavish spending not for utility but to signal social standing and emulate higher classes, thereby establishing emulation as a key driver of consumption patterns. This perspective highlighted how consumption serves as a mechanism for social differentiation, laying early groundwork for understanding relative rather than absolute income effects on behavior. In the early 20th century, John Maynard Keynes's 1936 formulation of the consumption function in The General Theory of Employment, Interest and Money posited a stable relationship between absolute income and consumption, with a marginal propensity to consume less than one. However, empirical observations during economic cycles revealed limitations in this absolute income approach, as cross-sectional data showed average propensities to consume declining with income levels, and short-run behaviors during booms and busts suggested influences beyond current income, such as distributional and comparative factors. These shortcomings underscored the need for theories incorporating relative considerations to better explain savings rates and consumption volatility. Sociological perspectives further enriched pre-1940s economic literature by emphasizing emulation and social status in consumption decisions. Hazel Kyrk's 1923 book A Theory of Consumption argued that consumption standards are socially determined, with individuals adjusting spending to meet community norms and achieve social adequacy rather than mere physiological needs, integrating institutionalist views on how societal pressures shape economic choices.^[4] This body of work, drawing from Veblen's institutional economics, portrayed consumption as embedded in social hierarchies, where relative position influences aspirations and expenditures, providing a conceptual bridge to later formalizations. These ideas culminated in James Duesenberry's 1949 synthesis in Income, Saving, and the Theory of Consumer Behavior.

Duesenberry's Formulation

James Stemple Duesenberry, an American economist born in 1918 in Princeton, West Virginia, earned his bachelor's degree in 1939 and master's degree in 1941 from the University of Michigan, where he also completed his Ph.D. in 1948 after serving as a statistician in the U.S. Air Force during World War II.^[5] After the war, he joined MIT as an instructor in 1946 and the Harvard University faculty as an assistant professor in 1948, rising to full professor in 1955 and serving until his retirement in 1989. He died on October 5, 2009. Duesenberry's seminal contribution to consumption theory came in his 1949 book, Income, Saving, and the Theory of Consumer Behavior, published by Harvard University Press, which formalized the relative income hypothesis as a framework for understanding household saving and spending decisions.^[1] The relative income hypothesis emerged in the post-World War II era as Duesenberry sought to address shortcomings in John Maynard Keynes's absolute income hypothesis, which posited that consumption depends primarily on current absolute income levels and implied a stable average propensity to consume over time.^[6] Drawing on empirical data from U.S. household surveys and national accounts during the Great Depression and wartime recovery of the 1930s and 1940s, Duesenberry observed that consumption patterns did not align with absolute income predictions; instead, saving rates appeared to remain relatively stable as aggregate income rose, challenging the Keynesian model's assumptions about independent utility maximization.^[7] His work built briefly on earlier Veblenian ideas of social emulation, where individuals' consumption is influenced by comparisons with peers, but Duesenberry grounded this in macroeconomic evidence to explain aggregate behavior.^[8] Duesenberry's ideas originated in his doctoral research at Michigan during the mid-1940s, where he examined business cycles and wage dynamics in industries like automobiles, laying the groundwork for his critique of neoclassical consumption models.^[9] The 1949 book, based on this dissertation-era analysis, received prompt attention in academic journals; notably, Kenneth Arrow's review in the American Economic Review praised its potential to reshape consumer theory by integrating social and historical factors into Keynesian frameworks, though he noted challenges in formalizing its implications. Initial reception highlighted the hypothesis's explanatory power for postwar consumption booms but sparked debates on its compatibility with rational choice assumptions, influencing subsequent developments in behavioral economics.^[10]

Theoretical Foundations

Core Principles

The relative income hypothesis posits that an individual's utility from consumption is not derived solely from the absolute level of their income or goods acquired, but rather from comparisons with the income and consumption levels of others in their social reference group, resulting in interdependent preferences.^[1] This social dimension implies that satisfaction with one's own consumption diminishes if others in the relevant peer group—such as neighbors, colleagues, or community members—achieve higher standards, prompting adjustments in spending to maintain a perceived relative position.^[1] For instance, a family might increase expenditures on housing or vehicles to align with the visible consumption patterns of affluent neighbors, even if their absolute income remains unchanged.^[2] Central to this framework is the role of relative position within the income distribution, where an individual's propensity to consume rises as they seek to match or exceed the average consumption of their reference group, thereby influencing saving rates based on percentile standing rather than total earnings.^[1] This contrasts with views centered on absolute income, which treat consumption decisions as isolated from social context.^[11] The hypothesis underscores that lower-ranked individuals in the distribution exhibit higher consumption propensities due to the pressure to emulate those above them, while those at the top may save more as their relative superiority reduces the need for demonstrative spending.^[1] Psychological mechanisms drive these behaviors, including emulation, where individuals mimic the consumption standards of higher-status groups to preserve self-esteem and social standing; demonstration effects, through which exposure to others' superior goods—such as a colleague's luxury purchase—generates dissatisfaction and stimulates one's own spending impulses; and status-seeking, motivated by the societal imperative to signal success via material acquisitions.^[1] These factors distinguish the relative income approach from models of purely rational utility maximization, as they incorporate invidious social comparisons that make preferences dynamic and context-dependent, rather than fixed and individualistic.^[6]

The Two Hypotheses

James S. Duesenberry's relative income hypothesis comprises two interrelated components that explain consumer behavior through social and historical influences on spending. The first hypothesis asserts that an individual's consumption decisions are primarily driven by their relative income position within a reference group, such as family, peers, or community, rather than absolute income levels. This relative position is typically measured by the individual's percentile ranking in the group's income distribution, where lower-ranked individuals tend to consume a higher proportion of their income to align with group norms.^[12] The second hypothesis introduces the concept of consumption irreversibility, often termed the ratchet effect, whereby households' spending patterns become anchored to the highest income level previously attained. Even if current income falls below this peak, consumption does not adjust downward proportionally; instead, individuals maintain elevated spending by reducing savings or other adjustments to preserve accustomed living standards. This resistance to decline stems from established habits and social expectations formed during periods of higher income.^[12] These two hypotheses interconnect through mechanisms of social emulation, where ongoing relative comparisons within reference groups sustain and amplify the ratchet effect over time. As individuals observe and aspire to the consumption levels of higher-income peers, past benchmarks of peak income gain reinforced significance, perpetuating high consumption norms even amid economic downturns or personal income reductions. This dynamic underscores how relative positioning not only shapes immediate spending but also entrenches long-term behavioral patterns.^[13]

Mathematical Representation

Consumption Function

In the relative income hypothesis, the consumption function is formulated such that an individual's consumption C depends on their relative income Y_r, defined as the ratio of current income Y to a reference income Y_m (such as the mean income of the reference group or the past peak income). The general form is thus C = f(Y_r) \cdot Y, where f(Y_r) represents the average propensity to consume (APC), which is a decreasing function of Y_r.^[1] This structure arises from the demonstration effect, where consumption is driven by social comparisons: as relative income Y_r increases, individuals experience reduced pressure to match peers' consumption levels, leading to a lower marginal propensity to consume (MPC) out of incremental income. Consequently, the MPC diminishes with rising Y_r, and the APC falls at higher relative income positions within the group, as a larger share of income is allocated to savings to sustain social standing.^[1] Duesenberry derived this through interdependent utility functions, where an individual's utility U_i depends on their consumption relative to a weighted average of others' consumption in the reference group: U_i = U_i\left[C_i / \sum \alpha_{ij} C_j\right], with \alpha_{ij} as weights reflecting social proximity. This implies the consumption ratio C_i / R_i = f(Y_i / R_i, A_i / R_i), where R_i = \sum \alpha_{ij} C_j is the reference consumption level, Y_i is income, and A_i is assets.^[1] An empirical representation from Duesenberry's analysis of U.S. data expresses the average propensity to save (APS) as a linear function of relative income to past peak: \frac{S_t}{Y_t} = 0.25 \left(\frac{Y_t}{Y_0}\right) - 0.196, where S_t is savings, Y_t is current disposable income, and Y_0 is the previous peak income. The corresponding APC is then APC = 1 - 0.25 \left(\frac{Y}{Y_0}\right) + 0.196, illustrating how APC declines as current income approaches or exceeds the reference peak.^[1]

Ratchet Effect Modeling

The ratchet effect describes the path-dependent nature of consumption behavior in the relative income hypothesis, where consumption expenditures increase with rising income but decline only modestly—or not at all proportionally—when income falls, owing to entrenched social norms and the difficulty of downgrading established living standards. This irreversibility stems from individuals' reluctance to reduce consumption below levels attained during prior income peaks, as doing so would imply a loss of social status relative to peers or one's own past circumstances. To model this dynamic, the reference income is defined recursively to capture the upward-only adjustment: Y_{\mathrm{ref},t} = \max(Y_t, Y_{\mathrm{ref},t-1}), ensuring the reference level locks in the highest prior income and only updates upon surpassing it. Consumption is then expressed relative to this reference, often in ratio form as \frac{C_t}{Y_t} = a - c \frac{Y_t}{Y_{\mathrm{ref}}}, where a and c > 0 are parameters, and the term \frac{Y_t}{Y_{\mathrm{ref}}} embeds the relative standing. When current income Y_t falls below the reference Y_{\mathrm{ref}}, the ratio \frac{Y_t}{Y_{\mathrm{ref}}} < [1](/page/1), making the subtraction smaller in magnitude and thus elevating the average propensity to consume (APC) above its long-run equilibrium. This formulation integrates with the broader consumption function by introducing time dependence through the reference level.^[12] In the long run, the ratchet effect accounts for persistently elevated APC values despite overall income growth, as consumption remains tethered to historical peaks, preventing full adjustment downward during economic contractions and leading to higher aggregate consumption stability. Graphically, this manifests as a series of short-run consumption functions that ratchet upward at income peaks—shifting parallel to the long-run function—but remain elevated during subsequent declines, producing a nonlinear, asymmetric path in consumption-income space that resembles a ratcheting mechanism rather than a smooth curve.^[14]

Comparisons with Alternative Theories

Absolute Income Hypothesis

The absolute income hypothesis, formulated by John Maynard Keynes in his 1936 work The General Theory of Employment, Interest, and Money, posits that household consumption expenditure depends primarily on the absolute level of current disposable income.^[15] Keynes represented this relationship through a linear consumption function: C = a + bY, where C is consumption, Y is current disposable income, a is a fixed positive constant representing autonomous consumption (basic needs met even at zero income), and b (0 < b < 1) is the constant marginal propensity to consume (MPC), indicating the fraction of additional income devoted to consumption.^[15] Under this hypothesis, consumption is assumed to be a stable function solely of absolute current income, with no influence from past income, wealth, or relative positions.^[14] This implies that as income rises, the average propensity to consume (APC = C/Y) declines, since the MPC is less than 1 and autonomous consumption becomes a smaller share of total income; conversely, during income falls, the APC rises.^[14] Keynes developed the absolute income hypothesis amid the Great Depression to explain short-run consumption behaviors, which contributed to economic stagnation by reducing aggregate demand through the multiplier effect. However, the hypothesis faces limitations in accounting for long-run consumption patterns, as empirical evidence from cross-sectional and time-series data shows a relatively stable APC over extended periods, rather than the predicted continuous decline with rising income levels.^[14] This shortcoming in explaining long-term stability prompted extensions like the relative income hypothesis.^[16]

Life-Cycle and Permanent Income Hypotheses

The life-cycle hypothesis, developed by Franco Modigliani and Richard Brumberg in 1954, posits that individuals plan their consumption to smooth spending over their entire lifetime, rather than adjusting it strictly to current income fluctuations. According to this model, consumption is determined by expected total lifetime resources, which include current financial wealth, anticipated future earnings (human capital), and other assets. The basic consumption function can be expressed as C = k (W + H), where C is consumption, k is a constant proportion (typically between 0 and 1), W represents non-human wealth, and H denotes the present value of future human capital or labor income. This forward-looking approach implies that young individuals with low current income may borrow to maintain higher consumption, while those in middle age save from peak earnings, and retirees draw down assets to sustain spending, thereby stabilizing utility across life stages.^[17] Building on similar intertemporal optimization ideas, Milton Friedman's permanent income hypothesis, introduced in 1957, differentiates between permanent income—reflecting an individual's long-term average expected earnings—and transitory income, which consists of temporary deviations like windfalls or short-term losses. Friedman argued that consumption primarily responds to changes in permanent income, with a high marginal propensity to consume (MPC) applied to it, while transitory income has a low or near-zero MPC, as it is largely saved or used to offset shocks. The core equation is C = k Y_p, where Y_p is permanent income and k is the propensity to consume out of permanent income, often estimated around 0.9 or higher. This framework explains why aggregate consumption appears smoother than measured income, as households base spending decisions on rational expectations of stable long-term resources rather than volatile current flows.^[18] Both the life-cycle and permanent income hypotheses emerged as critiques of earlier static models, much like the relative income hypothesis, by emphasizing individual forward planning and expectations to resolve observed consumption-income discrepancies. In contrast to the relative income hypothesis, which attributes consumption patterns to social comparisons and keeping up with peers' spending levels, these models focus on autonomous lifetime resource allocation without reliance on interpersonal reference groups, thereby addressing puzzles like the cross-sectional variation in savings rates through personal optimization rather than demonstration effects. Friedman's analysis explicitly relates the permanent income framework to relative income ideas, noting that while relative considerations might influence perceptions of permanent income, the core mechanism remains individualistic and expectation-based.^[19]

Empirical Evidence and Testing

Early Empirical Support

James S. Duesenberry provided the initial empirical foundation for the relative income hypothesis in his 1949 book Income, Saving, and the Theory of Consumer Behavior, analyzing U.S. household data from the 1930s and 1940s. Drawing on cross-sectional data from the 1935–36 Study of Consumer Purchases and 1941 budget studies conducted by the Bureau of Labor Statistics, he showed that the average propensity to consume (APC) declines systematically with a household's relative income rank within the income distribution. For example, savings ratios increased with percentile position in the distribution, regardless of absolute income levels, as lower-ranked households emulated the consumption standards of higher-ranked ones. This pattern held across urban and rural samples, with APC falling from over 100% (indicating deficits) in the lowest income percentiles to around 70–80% in the highest, underscoring the role of social comparisons in consumption decisions.^[1] Subsequent studies in the 1950s and 1960s built on Duesenberry's work, confirming relative income effects through U.S. household surveys. Robert Ferber's comprehensive review in 1962 synthesized evidence from multiple U.S. datasets, including postwar consumer expenditure surveys, demonstrating that relative income measures—such as position within community or occupational income distributions—significantly influenced consumption and saving behavior. These studies showed that relative factors contributed to explaining variations in consumption expenditures, beyond what absolute income alone could account for.^[20] A prominent empirical validation of the hypothesis came from observations of the ratchet effect in post-war boom data, where consumption failed to revert after temporary income peaks. Duesenberry's examination of 1940s U.S. data revealed that households exposed to higher incomes during wartime prosperity sustained elevated consumption levels even as peacetime incomes fell, with savings rates remaining suppressed relative to pre-boom baselines. This asymmetry was evident in aggregate time-series data from the late 1940s, where the APC did not rise proportionally during the 1948–49 recession, consistent with the demonstration and ratchet mechanisms of the relative income framework. Later analyses of the 1950s U.S. expansion reinforced this, showing persistent upward shifts in consumption functions that aligned with relative income dynamics rather than absolute income fluctuations.^[1]

Recent Studies and Applications

A 2022 macroeconomic study on Ethiopia utilizing quarterly data from 1999 to 2019 found strong support for Duesenberry's relative income hypothesis, particularly the ratchet effect, where past consumption levels persistently influence current spending patterns among lower-income groups in developing economies. The analysis, employing an autoregressive distributed lag model, revealed a backward-J-shaped relationship in the demonstration effect, indicating that relative income changes lead to sharper declines in the average propensity to consume for poorer households, thereby explaining a substantial portion of consumption dynamics in resource-constrained settings.^[21] In health applications, a 2021 study linked to the National Institutes of Health examined relative income effects on elderly health outcomes in China using panel data from the Chinese Longitudinal Healthy Longevity Survey. It demonstrated that relative income—measured against peers—exerts a significant negative influence on health performance, independent of absolute income levels, with income inequality metrics amplifying psychosocial stress and contributing to poorer self-reported health among lower-ranked individuals. This supports the extension of the hypothesis to non-economic domains, where social comparisons exacerbate health disparities. A 2024 study on UK civil servants further extended this to mental health, finding that relative income has a stronger negative association with psychological distress than absolute income, using longitudinal data from 1985–2019.^[22]^[23] Evidence from emerging markets in the 2020s shows mixed yet predominantly positive relative income effects. A 2021 analysis of Pakistani data from 1986 to 2016 confirmed the prevalence of both income and habit ratchet effects, with long-run marginal propensities to consume approaching unity, suggesting households prioritize maintaining relative living standards over savings, though short-run effects were moderated (0.43–0.66). Similarly, a 2022 study on Central, Eastern, and Southeastern Europe, including Croatia, found that higher income inequality correlates positively with indebtedness for upper-income households via a "keeping up" mechanism, while lower-income groups face restricted access to credit, highlighting demand-side relative pressures in transitional economies.^[24]^[25] A 2015 methodological comparison using UK household panel data underscored measurement challenges in testing the hypothesis, as relative income effects varied by reference group definitions (individual vs. spatial) and estimation techniques (e.g., fixed effects vs. random effects ordered probit), yielding both positive and negative utility impacts but overall affirming the hypothesis's robustness when accounting for endogeneity. To address gaps in behavioral evidence, analyses of World Values Survey data have integrated relative income metrics with life satisfaction responses across global samples, revealing that perceived income rank relative to national peers stronger predicts subjective well-being than absolute levels.^[26]^[27]

Criticisms and Limitations

Theoretical Critiques

One key theoretical critique of the relative income hypothesis concerns its assumption of uniform interdependence in consumption behavior, where individuals are posited to base their consumption primarily on comparisons within a homogeneous reference group. This overlooks the heterogeneity of social networks and varying intensities of emulation across individuals, leading to an oversimplified model of social influence. For instance, Holländer (2001) argues that Duesenberry's framework fails to adequately validate interpersonal utility interdependence under standard economic theory, as it assumes consistent reference group dynamics without accounting for diverse emulation motivations or network structures that can alter comparison intensities.^[28] The hypothesis has also been faulted for its sociological overemphasis, which prioritizes relative comparisons driven by social and psychological factors but lacks robust micro-foundations to explain why such interdependence dominates individual decision-making. In neoclassical economics, this vulnerability arises from the absence of a clear optimization framework for agents, making the model susceptible to rational choice rebuttals that emphasize isolated, utility-maximizing behavior over social emulation. Critics, including Friedman (1957) and Pollak (1976), rejected the hypothesis for incorporating interdependent preferences that conflict with mainstream isolationist methodology, viewing its reliance on demonstration effects as ad hoc and insufficiently grounded in individual rationality.^[29]^[30] Furthermore, the relative income hypothesis is critiqued for its predominantly static structure, which focuses on current and past relative positions without fully integrating forward-looking behavior, rendering it less adaptable to economic uncertainty than dynamic alternatives. Unlike the permanent income hypothesis, which incorporates expectations of lifetime resources to smooth consumption over time, Duesenberry's model remains backward-oriented and tied to immediate social contexts, limiting its ability to address intertemporal choices under volatility. This static emphasis, as critiqued by Arrow (1950), undermines the hypothesis's explanatory power in evolving economic environments where agents anticipate future income fluctuations.^[31]

Empirical Challenges

One major empirical challenge in testing the relative income hypothesis (RIH) arises from measurement problems, particularly the difficulty in defining appropriate reference groups and measuring relative income accurately. Studies have shown that results vary significantly depending on whether reference groups are defined locally (e.g., neighborhood or workplace peers) or more broadly (e.g., national or regional averages), leading to inconsistent findings across empirical analyses. For instance, when reference groups are constructed based on self-reported peers versus objective demographic matches, the estimated effects of relative income on consumption or well-being can differ substantially, complicating comparisons and generalizability.^[26] Endogeneity and reverse causality further undermine causal inference in RIH tests, as consumption patterns may influence income inequality rather than the reverse, creating bidirectional relationships that bias standard regression estimates. This issue is evident in studies where mixed signs—positive or negative effects of relative income—are observed, often due to unaddressed endogeneity in self-reported or lagged variables; for example, econometric models accounting for these through panel fixed effects still yield ambiguous results, with relative income sometimes appearing to boost rather than suppress utility.^[26] Evidence from post-1980s data suggests a declining relevance of the RIH, particularly in high-mobility societies where social comparisons may weaken over time. Panel data analyses from this period, such as those using British household surveys from the 1990s onward, frequently fail to find significant associations between income inequality and outcomes like health or consumption, with instrumental variable (IV) methods and fixed-effects models often unable to reject the null hypothesis of no relative income effect. This shift implies that absolute income or other factors may dominate in modern, dynamic economies, rendering earlier RIH support less robust.^[32]

Modern Applications

Behavioral Economics

The relative income hypothesis, originally proposed by James Duesenberry in 1949, aligns closely with key concepts in prospect theory, particularly the ratchet effect in consumption, where individuals resist reducing spending after income rises due to heightened reference standards set by peers or past levels.^[7] This resistance mirrors loss aversion, as articulated by Kahneman and Tversky (1979), wherein losses relative to a reference point—such as one's position in a social hierarchy—are experienced more intensely than equivalent gains, leading to asymmetric responses in utility from relative income changes. Empirical analyses of happiness data further support this integration, showing that utility functions are concave in both positive and negative relative income domains, with loss aversion causing falling behind others to diminish well-being more sharply than surpassing them enhances it.^[33] Post-2000 laboratory experiments have provided robust evidence that manipulations of relative income influence subjective happiness and spending behaviors, reinforcing the hypothesis within behavioral economics. For instance, in controlled settings, participants exposed to information about peers' higher earnings report lower income satisfaction despite unchanged absolute income, highlighting the psychological weight of social comparisons. Similarly, online experiments inducing exogenous shocks to perceived relative standing demonstrate that individuals derive less happiness from personal gains when others fare better, with effects persisting across demographic groups. In ultimatum games, where proposers divide resources, the provision of social comparison information—revealing relative income positions—prompts higher offers to avoid rejection, as responders penalize perceived unfairness tied to status disparities, thus linking relative income to cooperative spending decisions. These studies, often using real-effort tasks, also show that relative earnings reduce charitable giving, as individuals prioritize maintaining their comparative position over absolute generosity. Behavioral extensions of the relative income hypothesis have incorporated reference-dependent preferences, notably through the model of Köszegi and Rabin (2006), which posits that expectations serve as endogenous reference points, updating Duesenberry's social comparison framework to account for anticipated relative outcomes in consumption choices. This integration allows for dynamic analysis of how psychological adaptations to expected peer incomes shape saving and spending patterns, bridging mid-20th-century sociology with 21st-century cognitive biases like expectation-based loss aversion.^[7] Such models have informed broader debates on income inequality by emphasizing how reference shifts amplify perceived disparities in well-being.^[33]

Policy Implications

The relative income hypothesis suggests that policies aimed at reducing income dispersion can mitigate relative deprivation effects, thereby stabilizing aggregate consumption and demand. Progressive taxation, by compressing income distributions, addresses the negative externalities arising from status-seeking behaviors where individuals derive utility from relative rather than absolute income positions. Such taxation can enhance allocative efficiency, particularly in relatively egalitarian economies, by curbing excessive labor supply driven by competitive consumption motives and potentially yielding Pareto improvements when pre-tax income inequality is low. For instance, models incorporating relative income concerns demonstrate that optimal tax progressivity decreases as pre-tax inequality rises, balancing incentives while countering positional externalities. The hypothesis's ratchet effect—whereby consumption resists downward adjustments after income peaks—implies asymmetric responses to economic cycles, with consumption proving sticky during recessions and providing a natural floor to aggregate demand. This stickiness amplifies fiscal multipliers for stimulus measures, as households maintain spending habits despite income declines, but it also heightens the risk of prolonged downturns if relative income gaps widen. Consequently, policymakers should prioritize targeted fiscal interventions, such as tax cuts or transfers directed at lower- and middle-income groups, over broad austerity measures, to leverage their higher marginal propensity to consume and avoid exacerbating downward spirals in demand. Redistribution-focused policies are thus more effective for demand stabilization, as they counteract the ratchet by supporting consumption among those most sensitive to relative positions.^[34] In the 2020s, the relative income hypothesis has informed the design of social safety nets in developing countries, emphasizing consumption-stabilizing programs that account for low positional concerns among the extreme poor to optimize aid distribution. Evidence from rural Ethiopia, where survey experiments revealed minimal relative income effects on utility from aid packages— with over 65% of respondents showing no positional preferences—supports policies allowing uneven transfers without significant welfare losses from perceived inequality. This informs scalable safety nets, such as Ethiopia's Productive Safety Net Programme, by prioritizing absolute consumption support over strict equality in benefits to enhance overall household resilience and aggregate stability in volatile low-income contexts. Behavioral economics provides micro-level evidence reinforcing these designs, validating the focus on relative deprivation thresholds in aid allocation.^[35]

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Absolute Income, Relative Income, and Happiness - ResearchGate
Aug 7, 2025 · This paper uses data from the World Values Survey to investigate how an individual's self-reported happiness is related to (i) the level of ...<|separator|>
[27]
https://www.researchgate.net/publication/225457293_Absolute_Income_Relative_Income_and_Happiness
[28]
Happiness and loss aversion: Is utility concave or convex in relative ...
The value function is also steeper for losses than for gains, which is referred to as loss aversion (Tversky and Kahneman, 1991). Finally, the value function is ...
[29]
THE RELEVANCE OF DUESENBERRY CONSUMPTION THEORY ...
In this paper we examine the to-date relevance of Duesenberry's Consumption Theory through an applied case to four economies in Latin America.Missing: reception reviews criticisms