Answer to Question #318311 in Economics of Enterprise for PMN

Question

Compare and contrast the permanent income hypothesis and the relative income hypothesis in explaining consumption behavior in a modern developing country such as Kenya. (8marks)

Answer 1

Permanent income hypothesis in consumer spending projects that consumers will spend in accordance to their expected long-term average income. Permanent income refers to the mean income, determined by anticipated income to be received over a long period of time. The theory assumes an average propensity to consume. Relative income hypothesis in consumer spending states that current consumption is dependent on current income, relative to previous peak income. The theory assumes that basic consumption function is long-run and proportional and thus, the average fraction of income consumed does not change in the long run, though there may be variations between consumption and income within short run cycles.