Theory of Relative Income

GP Sir
Posted by GP Sir 3 weeks Ago

Historical development of Theory of Relative Income

Fred Hirsch, an economist, first described the Theory of Relative Income in his 1976 book “The Social Limits to Growth.” Hirsch found that people evaluate their level of well-being concerning their peers’ income rather than just their absolute income. As a result, the Theory of Relative Income was created, which focuses on how relative income affects a person’s behavior and well-being.

Explanation of the Theory of Relative Income

According to the Theory of Relative Income, people are more concerned with their relative income than their absolute income. The theory holds that if a person’s relative income decreases or stays the same, their absolute income will not always increase their well-being. People would not feel better off even though their absolute income increased if everyone in a community received a 10% pay raise, but the cost of living increased by 20%.

theory-of-relative-income

According to the Theory of Relative Income, people should assess their well-being by comparing their income to those around them. Individuals might feel proud and satisfied if their income exceeds their peers. On the other hand, even if their absolute income is higher than before, if their income is lower than that of their peers, they may feel frustrated and unfulfilled.

Read: Sustainable Population Growth Theory

Assumptions of Theory of Relative Income

The Theory of Relative Income is based on several critical assumptions listed below:

  1. People assess their income as those of others in the same reference group.
  2. Social norms, such as occupation, education, and income level, define the reference group.
  3. Individuals care about their relative income or position within their reference group, not just their absolute income level.
  4. Changes in income inequality affect individual behavior and well-being, not just changes in average income.
  5. Higher income inequality leads to higher status competition and consumption competition.
  6. Individuals are willing to pay the price to maintain or improve their relative income, such as working longer hours, putting up with more stress, or preceding leisure time.
  7. Pursuing relative income can lead to a zero-sum game, where some gains come at the expense of others.
  8. People constantly compare themselves to others and adjust their reference groups due to relative income concerns, which can negatively affect economic growth and happiness or well-being.
  9. Individual well-being and social welfare can be improved by public policies and social norms that reduce income inequality and status competition.

The Theory of Relative Income’s main propositions

According to economist Fred Hirsch’s 1976 theory of relative income, people’s well-being and satisfaction are determined by their absolute income level and relative income. According to the theory, individuals evaluate their income levels compared to others in their social group or reference group rather than in isolation. As a result, an increase in absolute income may not always increase subjective well-being if others in the reference group experience a proportionately greater increase in income.

The main propositions of the theory of relative income are:

  1. Income is evaluated relative to a reference group: People frequently compare their income levels to those in their reference group, which may include family, friends, coworkers, and neighbors. This reference group may differ between individuals and change over time as one’s social circle changes.
  2. Social norms define the reference group: The reference group is not just a random group of people; it is defined by social norms that influence people’s expectations and aspirations. Cultural, religious, or ideological beliefs and expectations based on education, occupation, or social class are examples of norms.
  3. There is a positional competition for income: People compete for status and recognition within their peer group, and income is one way to do so. As a result, increasing one’s income may not necessarily improve one’s well-being if it does not improve one’s relative position within the reference group.
  4. Relative deprivation may lead to social unrest: People may experience relative deprivation when they perceive a significant gap between their income and their reference group, leading to frustration, resentment, and even social unrest. As a result, reducing income inequality and promoting social mobility may be critical for ensuring social stability.

Mathematical interpretation of Theory of Relative Income

The Theory of Relative Income can be mathematically represented as follows:

U=f(Yi, Yavg)

Where:

  • U is the individual’s utility or well-being
  • Yi is the individual’s income
  • Yavg is the average income of the reference group

The function f represents the relationship between income and utility, considering the individual’s income relative to the average income of the reference group.

According to the theory, the marginal utility of income is determined by the individual’s income and the income of others in their reference group. As a result, people may be concerned not only with their absolute income level, but also with their income relative to others.

This can be mathematically represented as follows:

dU/dYi > 0 dU/dYavg < 0

Where:

  • dU/dYi represents the marginal utility of income for the individual
  • dU/dYavg represents the marginal disutility of income due to comparison with others

According to the theory, individuals derive utility not only from their income but also from their relative position within the reference group. As a result, even if their absolute income level remains constant or increases, individuals may experience a decrease in utility if their income falls relative to the reference group.

Criticisms of the Theory of Relative Income

Here are some major criticisms of the Theory of Relative Income:
  1. Subjective Nature of Relative Income: The subjective nature of the relative income theory is one of its major criticisms. The term “relative income” is difficult to define. People may have different ideas about what constitutes a high or low income compared to their peers. As a result, measuring or comparing relative income across different individuals or groups may be impossible.
  2. Neglects Absolute Income: Another criticism is that the relative income theory ignores absolute income. People may be concerned with their absolute income level and relative income level. Even if people outperform their peers, they may be dissatisfied with low absolute income.
  3. Ignores Non-Income Factors: According to the relative income theory, income is the only factor influencing people’s well-being. Non-income factors such as education, health, social status, and job satisfaction, on the other hand, can have a significant impact on well-being. As a result, the theory may not fully capture the complexities of people’s preferences and behavior.
  4. Fails to Explain Income Inequality: The theory of relative income does not explain why there is income inequality. It only explains why people may be unhappy with their income level compared to others. As a result, it may be ineffective for policymakers seeking to reduce income inequality.
  5. Does not Account for Cultural Differences: The relative income theory assumes that people behave consistently across cultures and societies. Cultural differences, on the other hand, can influence people’s preferences and behavior. As a result, the theory may not be applicable in all situations.