However, whether or not the permanent income hypothesis turns out to be valid, there is little doubt that, to quote Tobin, “This is one of those rare contributions of which it can be said that research and thought in its field will not be the same henceforth”. Most of all, it has led to under spread recognition of the possible effects of variability in income on consumption patterns and has provided a theoretical basis for measuring these effects as a springboard for a more realistic theory of consumer behaviour. Friedman divides the family’s measured income in the year into permanent income and transitory income. The measured (actual) income is larger or smaller than its permanent income, depending on the sum of positive and negative transitory income components. For example, if a worker gets special bonus in a year and does not expect to get it again, this income element is positive transitory income and it has the effect of raising his actual (measured) income above his permanent income.

1. Such a simple linear consumption function is to be found in nearly all introductory macroeconomic textbooks.
2. By wealth, Tobin means liquid assets, mainly cash, bank deposits, and savings bonds.
3. A family’s permanent income in any one year is in no sense indicated by its current income for that year but is determined by the expected income to be received over a long period of time, stretching out over a number of future years.
4. As income rises, the theory asserts that consumption will also rise, but not necessarily at the same rate.[2] When applied to a cross section of a population, rich people are expected to consume a lower proportion of their income than poor people.
5. According to Friedman, “Permanent income is to be interpreted as the mean income regarded as permanent by the consumer unit in question, which in turn depends on its farsightedness”.

Since the PIH argues that proper consumption function relates permanent consumption to permanent income, it concludes that the long-run consumption-income relationship is proportional. Changes in permanent income give rise to proportional changes in permanent consumption. This theory like the relative income theory, holds that the basic relationship between consumption and income is proportional, but the relationship here is between permanent consumption and permanent income. Thus, quite a different approach to the role of income in the theory of consumer spending has been developed by Milton Friedman. The main point of departure is the rejection of the common concept of current income and its replacement by what he calls permanent income. Consequently, the APC remains constant and the increase in total consumption expenditure is proportional to the increase in total income.

What is the difference between comparative and absolute advantage, by example?

A clear example of a nation with an absolute advantage is Saudi Arabia, a country with abundant oil supplies that provide it with an absolute advantage over other nations. Each country needs a minimum of four tubs of butter and four slabs of bacon to survive. In a state of autarky, producing solely on their own for their own needs, Atlantica can spend one-third of the year making butter and two-thirds of the year making bacon, for a total of four tubs of butter and four slabs of bacon.

Absolute Income Hypothesis (With Diagram) Marco Economics

In fact, other factors, such as capital and natural resources, can also affect unit costs. For example, capital such as more technologically advanced machines allows us to produce output at a lower cost. In the above case, the price of clothing in Malaysia is lower than in Indonesia because it bears lower opportunity costs than in Indonesia.

Absolute theory

As a result, they make at a lower absolute cost per unit than other countries. The absolute advantage was introduced by Adam Smith in the late 18th century. When we learn about international trade, this theory becomes the main introduction, in addition to comparative advantage.

The AIT argues that these factors have caused the short-run, non-proportional consumption function to shift upward in a manner that creates an illusion of proportionality, thereby obscuring the basic non-proportional relationship. Brown has explained that absolute hypothesis the relationship between income and consumption is non-proportional and rests upon habit persistence among consumers. According to Brown, “The full reaction of consumers to change in income does not occur immediately but instead takes place gradually”.

Thus, according to the RIT, changes in current consumption are not proportional to the changes in current income only when current income increases relative to previous peak income. In the years following the appearance of the General Theory, economists generally accepted the absolute income theory as basically correct, but the widespread acceptance enjoyed by this theory was short-lived. Doubts about the adequacy of the absolute income hypothesis arose because of its apparent inability to reconcile budget data on saving with observed long-run trends. Estimates of national saving and other aggregate derived by Kuznets and later by Goldsmith indicated that the aggregate saving ratio had remained virtually constant since the 1870s. Yet budget studies showed that the saving ratio rose substantially with income level.

It spite of these arguments the permanent income hypothesis is by no means established. Critics argue that it puts too great a stress on the expectations and long-range planning of consumer units, while in reality consumer units change their consumption behaviour frequently. Further, on the theoretical plane, question is raised regarding the validity of the two central tenets of the theory, namely, the independence of k of the level of income, and the lack of correlation between transitory consumption and transitory income. In other words, the MPC out of transitory or windfall income is Zero and the MPS is unity. It is, therefore, clear that if current consumption is unrelated to transitory income, the consumption- income relationship is non-proportional in the short-run.

The theory of absolute advantage represents Adam Smith’s explanation of why countries benefit from trade, by exporting goods where they have an absolute advantage and importing other goods. While the theory is an elegant and simple illustration of the benefits of trade, it did not fully explain the benefits of international trade. That would later fall to David Ricardo’s theory of comparative advantages. It is very difficult to determine the behaviour of consumption over a period of time. All that we learn from Keynes’ psychological law of consumption is that in the short period (cyclically) the consumers do not spend the entire increment of income and the MPC is less than one.

Presumably, if the factors that cause the upward shifts in the short-run function were to remain constant or cease to be important, only the short- run consumption function would be observed. For a sample group with average income above the national average measured income (Y1) exceeds permanent income (YP1). At (CP1) level of consumption (i.e., point B) average measured income for this sample group ex­ceeds permanent income, YP1. According to Keynes’ psychological law of consumption, an increment in income leads to less than proportionate increase in consumption so that marginal propensity to consume goes on declining as income increases, but the marginal propensity to save rises.

Absolute, Relative and Permanent Income Hypothesis (With Diagram)

Let us first consider a sample group of population having an average income above the population average. The hori­zontal difference between the short run and long run consumption functions (points N and B and points M and A) describes the transi­tory income. Measured income equals perma­nent income at that point at which these two consumption functions intersect, i.e., point L in the figure where transitory income in zero. Duesenberry’s first hypothesis says that consumption depends not on the ‘absolute’ level of income but on the ‘relative’ income— income relative to the income of the society in which an individual lives.

“…men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income”. The slope of the consumption function refers to the marginal propensity to consume. Another reason for these upward shifts in the consumption function has to do with the introduction of new products. The introduction of new goods, it is claimed, https://1investing.in/ stimulates consumption as these goods come to be regarded as essential for the good life. If this is true, a steady procession of new goods produces upward shifts in the consumption function. But what is baffling and puzzling to us that the empirical studies suggest two different consumption functions a non-proportional cross-section function and a proportional long run time-series function.

It explains the relationship between income and consumption, where real consumption is a positive function of real income. That is, an increase in income leads to an increase in consumption expenditure. However, this increase is less than proportionate, meaning that the percentage increase in consumption is less than the increase in income. Resource-poor countries can focus on products with lower opportunity costs than other countries. In contrast, resource-rich and resource-poor countries may still benefit from trade if they focus on their comparative advantage. This theory is based on opportunity cost, which is the next best alternative we sacrifice when we choose to produce a particular good.