4.2 Theories of Consumption

Consumption theories are crucial in understanding how people spend and save money. These models, including the Absolute Income, Relative Income, Life-Cycle, and Permanent Income Hypotheses, offer different perspectives on what drives consumer behavior.

Each theory has unique implications for saving patterns, policy decisions, and economic outcomes. By comparing these models, we gain insights into how income, age, and expectations shape consumption choices, helping economists and policymakers make informed decisions about fiscal policy and economic growth.

Consumption Theories: A Comparison

Absolute Income Hypothesis

Top images from around the web for Absolute Income Hypothesis

• 

  Theory of Consumer Choice | Boundless Economics View original

  Is this image relevant?

• 

  Equilibrium in the Income-Expenditure Model | Macroeconomics View original

  Is this image relevant?

• 

  Equilibrium in the Income-Expenditure Model | Macroeconomics with Prof. Dolar View original

  Is this image relevant?

• 

  Theory of Consumer Choice | Boundless Economics View original

  Is this image relevant?

• 

  Equilibrium in the Income-Expenditure Model | Macroeconomics View original

  Is this image relevant?

1 of 3

Top images from around the web for Absolute Income Hypothesis

• 

  Theory of Consumer Choice | Boundless Economics View original

  Is this image relevant?

• 

  Equilibrium in the Income-Expenditure Model | Macroeconomics View original

  Is this image relevant?

• 

  Equilibrium in the Income-Expenditure Model | Macroeconomics with Prof. Dolar View original

  Is this image relevant?

• 

  Theory of Consumer Choice | Boundless Economics View original

  Is this image relevant?

• 

  Equilibrium in the Income-Expenditure Model | Macroeconomics View original

  Is this image relevant?

1 of 3

• States that consumption is a function of current disposable income only
• Assumes a constant marginal propensity to consume (MPC) between 0 and 1
  • MPC measures the proportion of an additional dollar of disposable income that is consumed
  • Example: If MPC is 0.8, then 80 cents of each additional dollar of income will be consumed
• Implies a linear consumption function with a constant slope equal to the MPC

Relative Income Hypothesis

• Posits that consumption depends on an individual's income relative to others, rather than absolute income levels
• Suggests that people with lower relative income have a higher average propensity to consume (APC)
  • APC measures the fraction of total income that is consumed
  • Example: If a low-income household earns $30,000 and consumes$25,000, their APC is 0.83 (25,000/30,000)
• Implies a non-linear consumption function, with a higher APC for lower-income households

Life-Cycle Hypothesis

• Assumes that individuals plan their consumption and saving behavior over their entire lifetimes
• Suggests that people aim to smooth consumption across different stages of life
  • Borrow when young (e.g., student loans, mortgages)
  • Save during middle age (e.g., retirement accounts, investments)
  • Spend savings in retirement
• Predicts a hump-shaped saving pattern over an individual's lifetime
  • Negative saving when young
  • Positive saving during peak earning years
  • Dissaving (spending savings) in retirement

Permanent Income Hypothesis

• Distinguishes between permanent (expected long-term) and transitory (temporary) income
• Suggests that consumption is determined by permanent income, while transitory income changes are largely saved
  • Example: If a person receives a one-time bonus, they are likely to save most of it rather than increase consumption significantly
• Implies that the consumption function depends on permanent income, not current income

Implications of Consumption Theories

Consumption Function and Saving Behavior

• Absolute Income Hypothesis:
  • Consumption function is a straight line with a constant slope equal to the MPC
  • Saving is a residual determined by the difference between income and consumption
  • Example: If income is $50,000, MPC is 0.8, and consumption is$40,000, then saving is $10,000
• Relative Income Hypothesis:
  • Non-linear consumption function, with a higher APC for lower-income households
  • Income inequality can lead to lower aggregate saving rates
  • Example: If high-income households have a lower APC than low-income households, increasing income inequality may reduce overall saving
• Life-Cycle Hypothesis:
  • Hump-shaped saving pattern over an individual's lifetime
  • Aggregate saving depends on the age structure of the population
  • Example: An aging population with a larger proportion of retirees may have lower aggregate saving rates
• Permanent Income Hypothesis:
  • Consumption function depends on permanent income, while transitory income changes have little effect on consumption
  • Temporary income shocks (e.g., tax rebates) will primarily be saved rather than consumed
  • Example: If a household receives a $1,000 tax rebate, they may save most of it if they view it as a temporary income increase

Policy Implications

• Absolute Income Hypothesis:
  • Policies that increase disposable income (e.g., tax cuts, transfer payments) will raise consumption and aggregate demand
  • Policies that reduce disposable income will have the opposite effect
  • Example: A tax cut that increases disposable income by $1,000 per household may increase aggregate consumption by$800 (assuming MPC = 0.8)
• Relative Income Hypothesis:
  • Redistributive policies that reduce income inequality may increase aggregate consumption and economic growth
  • Example: Progressive taxation or targeted transfer payments that reduce income disparities could boost overall consumption
• Life-Cycle Hypothesis:
  • Policies related to retirement savings (e.g., pension systems, tax incentives) should account for the age structure of the population
  • Example: Encouraging retirement savings through tax-advantaged accounts (e.g., 401(k) plans, IRAs) can help individuals smooth consumption over their lifetimes
• Permanent Income Hypothesis:
  • Temporary fiscal policy measures (e.g., one-time tax rebates) may be less effective in stimulating consumption than permanent policy changes
  • Consumption may respond gradually to permanent income shocks
  • Example: A permanent tax cut may have a larger impact on consumption than a temporary tax rebate of the same amount

Evidence for Consumption Theories

Empirical Support

• Absolute Income Hypothesis:
  • Studies have found that the MPC is relatively stable over time, providing some support for the theory
  • However, the MPC may vary with income levels and economic conditions
  • Example: Research has shown that low-income households tend to have a higher MPC than high-income households
• Relative Income Hypothesis:
  • Empirical evidence for the Relative Income Hypothesis is mixed
  • Some studies find that relative income affects consumption and saving, while others find no significant effect
  • Example: A study by Duesenberry (1949) found that consumption patterns were influenced by the consumption of a household's reference group
• Life-Cycle Hypothesis:
  • Research generally supports the Life-Cycle Hypothesis, showing that saving rates vary with age and that consumption is smoother than income over the life cycle
  • However, some studies find that people undersave for retirement or fail to dissave as predicted
  • Example: Gourinchas and Parker (2002) found that consumption and saving patterns in the U.S. are broadly consistent with the Life-Cycle Hypothesis
• Permanent Income Hypothesis:
  • Tests of the Permanent Income Hypothesis have yielded varying results
  • Some studies find that consumption responds more strongly to permanent than transitory income, while others find significant effects of temporary income shocks
  • Example: A study by Bodkin (1959) found that consumption increased significantly in response to a one-time, unanticipated dividend payment, challenging the Permanent Income Hypothesis

Limitations and Challenges

• Absolute Income Hypothesis:
  • Does not account for the potential impact of wealth, expectations, or interest rates on consumption
  • Assumes a constant MPC, which may not hold in reality
  • Example: During economic downturns, the MPC may increase as households prioritize essential consumption over saving
• Relative Income Hypothesis:
  • Difficult to measure relative income and identify appropriate reference groups
  • May not fully explain aggregate consumption patterns
  • Example: The theory does not account for the potential impact of income growth on consumption, even if relative positions remain unchanged
• Life-Cycle Hypothesis:
  • Assumes that individuals have perfect foresight and can borrow and save freely to smooth consumption
  • Does not account for uncertainties, such as job loss or health issues, that can disrupt lifetime consumption plans
  • Example: The theory may overestimate the ability of households to smooth consumption in the face of unexpected shocks
• Permanent Income Hypothesis:
  • Difficult to distinguish between permanent and transitory income in practice
  • Assumes that individuals have access to complete information about their future income streams
  • Example: The theory may underestimate the impact of credit constraints on consumption behavior, particularly for low-income households

Applying Consumption Theories

Real-World Scenarios

• Absolute Income Hypothesis:
  • A recession that reduces disposable income will likely lead to a decline in consumption and aggregate demand
  • Example: During the Great Recession of 2008-2009, U.S. personal consumption expenditures fell by 2.5% as disposable income declined
• Relative Income Hypothesis:
  • Rising income inequality may lead to increased consumption among high-income households seeking to maintain their relative status
  • Example: The "keeping up with the Joneses" phenomenon, where households consume more to match the consumption patterns of their peers
• Life-Cycle Hypothesis:
  • An aging population may lead to lower aggregate saving rates and increased pressure on pension systems
  • Example: Many developed countries, such as Japan and Germany, face challenges related to aging populations and the sustainability of their retirement systems
• Permanent Income Hypothesis:
  • A permanent increase in government transfers (e.g., universal basic income) may have a larger impact on consumption than a one-time stimulus payment
  • Example: The Alaska Permanent Fund, which provides annual dividend payments to state residents, has been found to have a significant impact on household consumption

Policy Decisions

• Absolute Income Hypothesis:
  • Policymakers may use fiscal policy tools, such as tax cuts or transfer payments, to boost disposable income and stimulate consumption during economic downturns
  • Example: The U.S. government issued stimulus checks to households during the COVID-19 pandemic to support consumption and aggregate demand
• Relative Income Hypothesis:
  • Policies aimed at reducing income inequality, such as progressive taxation or minimum wage increases, may help to boost aggregate consumption
  • Example: Some countries, such as Sweden and Denmark, have implemented redistributive policies to reduce income disparities and support consumption
• Life-Cycle Hypothesis:
  • Policymakers may consider reforms to pension systems and retirement savings incentives to account for changing demographics and ensure adequate retirement income
  • Example: Automatic enrollment in employer-sponsored retirement plans, such as 401(k)s, can help to increase retirement savings and smooth consumption over the life cycle
• Permanent Income Hypothesis:
  • Policymakers may focus on long-term, structural reforms to boost permanent income, rather than relying on temporary stimulus measures
  • Example: Investments in education, infrastructure, and research and development can help to increase productivity and long-term economic growth, supporting permanent income growth