Relative Income Hypothesis

Background and two effects

Keynes's (1936) absolute income hypothesis held that consumption depends on current income and that the average propensity to consume falls as income rises. Long-run data, however, showed a nearly constant average propensity, creating the consumption function puzzle. In Income, Saving, and the Theory of Consumer Behavior (1949), James Duesenberry explained the puzzle by focusing on the social nature of consumption. The first element is the demonstration effect: people observe and emulate others' consumption, so spending depends on relative income position within a reference group more than on absolute income. A household living in a wealthy neighborhood consumes more than one with the same income elsewhere, extending Thorstein Veblen's (1899) analysis of conspicuous consumption. The second is the ratchet effect: once consumption habits rise they do not easily fall when income declines, so consumption depends on past peak income as well as current income.

Resolving the consumption puzzle

Under the demonstration effect, households high in the income distribution face less comparison pressure and so have a lower average propensity to consume in a cross-section; but in the long run, when everyone's income rises together, relative positions do not change and the consumption ratio stays constant. The ratchet effect explains why consumption falls less than income in recessions, temporarily raising the average propensity to consume, implying that consumption cushions downturns. The hypothesis is presented alongside Friedman's (1957) permanent income hypothesis and Modigliani's life-cycle hypothesis as a leading answer to the puzzle, but it was pushed to the margins of textbooks as rival theories grounded in individual optimization became mainstream (Mason, 2000).

Modern reassessment

The idea of relative income revived in happiness economics and finance. Richard Easterlin (1974) proposed the Easterlin paradox: within a country the rich are happier, yet average happiness rises little as national income grows over time, a pattern relative income can explain. Luttmer (2005) showed that higher neighbors' earnings reduce one's own well-being, holding own income constant, and Clark, Frijters and Shields (2008) surveyed extensive evidence of relative income effects. Robert Frank (1985, 2005) argued that competition over positional goods such as houses and cars creates positional externalities that harm everyone, and proposed a progressive consumption tax. In finance, Abel's (1990) "catching up with the Joneses" preferences and Campbell and Cochrane's (1999) habit formation model were used to explain the equity premium puzzle. Bertrand and Morse (2016) found trickle-down consumption, with middle-class spending and debt rising in areas where top incomes grew. The work also connects to research on relative deprivation.

FAQ

What is the relative income hypothesis in simple terms?

People spend based on how their income compares with those around them rather than on its absolute size, and once their living standard rises they find it hard to cut back even if income falls.

What are the demonstration and ratchet effects?

The demonstration effect is the tendency to copy the consumption of people around you; the ratchet effect is the tendency not to cut consumption back easily from a past high level when income falls.

Sources reviewed: 2026-10-26

References

1. Duesenberry, J. S. (1949). Income, Saving, and the Theory of Consumer Behavior. Cambridge, MA: Harvard University Press.
2. Veblen, T. (1899). The Theory of the Leisure Class. New York: Macmillan.
3. Keynes, J. M. (1936). The General Theory of Employment, Interest and Money. London: Macmillan.
4. Friedman, M. (1957). A Theory of the Consumption Function. Princeton: Princeton University Press.
5. Easterlin, R. A. (1974). Does economic growth improve the human lot? In P. A. David & M. W. Reder (Eds.), Nations and Households in Economic Growth (pp. 89–125). New York: Academic Press.
6. Frank, R. H. (1985). Choosing the Right Pond: Human Behavior and the Quest for Status. New York: Oxford University Press.
7. Frank, R. H. (2005). Positional externalities cause large and preventable welfare losses. American Economic Review, 95(2), 137–141.
8. Abel, A. B. (1990). Asset prices under habit formation and catching up with the Joneses. American Economic Review, 80(2), 38–42.
9. Campbell, J. Y., & Cochrane, J. H. (1999). By force of habit: A consumption-based explanation of aggregate stock market behavior. Journal of Political Economy, 107(2), 205–251.
10. Luttmer, E. F. P. (2005). Neighbors as negatives: Relative earnings and well-being. Quarterly Journal of Economics, 120(3), 963–1002.
11. Clark, A. E., Frijters, P., & Shields, M. A. (2008). Relative income, happiness, and utility. Journal of Economic Literature, 46(1), 95–144.
12. Bertrand, M., & Morse, A. (2016). Trickle-down consumption. Review of Economics and Statistics, 98(5), 863–879.
13. Mason, R. (2000). The social significance of consumption: James Duesenberry's contribution to consumer theory. Journal of Economic Issues, 34(3), 553–572.