The difference between relative income and absolute income, on the surface, can cause confusion for some people, but it centers on the issue of context. Relative income measures your income in relation to other members of society, weighing it against the current standards of the day. Absolute income, on the other hand, does not take into consideration those other factors, but simply reflects the total amount of earnings you've received in a given period.
Economist John Maynard Keynes created a theory of consumption based on people's absolute income. According to Keynes, consumers would spend a smaller percentage of their income as their absolute income grew larger, simultaneously increasing their savings rate. Data supported the theory, but when aggregate income grew there was not a similar growth in the aggregate savings rate. Still, standard economics asserts that individuals view their income and financial position in absolute terms.
James Duesenberry introduced the relative income hypothesis, which demonstrates that people make decisions, including savings and consuming, based not only on absolute income but on relative income as well. Duesenberry argued that consumers view their own social position and status in relation to others, and then behave accordingly. For instance, a consumer will consider his income as it relates to the income of another before making purchase decisions.
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Income and Well-Being
Many economists argue that absolute income is the best measurement of an individual's overall well-being. However, research indicates that measures of happiness have remained the same when the population's absolute income grows at a similar rate. But, the wealthy population shows higher levels of happiness than the poorer population because of more resources to enjoy themselves by taking vacations or traveling as well as having less stress stemming from the inability to pay for routine things. This evidence suggests that relative income is critical to our happiness and well-being. Absolute income has been linked to increased social tolerance, a cleaner environment and better health.
Contemporary Income Growth
Absolute income and relative income have diverged considerably in their measurements of income growth in the United States since the 1970s. Absolute income has grown at a much higher rate than median family earnings in the U.S., owing to an increased income inequality in the country. This means that the portion of the population not in the highest earnings brackets has seen its relative income decrease even as its absolute income climbs.