What Is the Difference Between Relative & Absolute Income?

By Motley Fool StaffFool.com

Which job situation would you prefer: Earning $50,000 per year while everyone around you makes $60,000; or earning $40,000 per year as others are taking home $30,000?

This question captures the difference between relative and absolute income.

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Absolute income "Absolute income" is an economic term that simply describes the amount of money that an individual is compensated for his or her work. Call it wages, salary, earnings, or take-home pay it's all income. And it is fundamental to the study of economics because your level of income forms the basis for decisions on how much time you'll choose to dedicate toward work (production) and on how much of the resulting money you'll choose to spend (consumption) as opposed to save.

Broadly speaking, consumption is understood to increase as income rises -- and to decrease as income falls. But the two figures don't usually move at exactly the same pace. Higher income families tend to put a greater percentage of their pay into savings while those on the lower end of the income scale dedicate less to savings.

Relative income"Relative income" refers to one's earnings in relation to average income. You can look at relative income as a simple comparison of two points as in the question above. There, we imagined two scenarios; one in which a person makes $50,000 while the average salary of his peers is $60,000; and another in which someone makes $40,000 as others earn $30,000. In the first case your income is low, relative to peers, while the opposite is true in the second example.

A more precise way to express relative income is by using percentile positions, which describe exactly how far your income is away from the average of the group. This is the approach behind referring to the "highest-paid 1%." Recent government statistics show, for example, that the median income for a full-time worker in the United States was $801 per week as of mid-2015. Yet that average conceals a huge range of salaries: Workers in the bottom 10% took home $384 per week while the top 10% earned $1,920 each week.

Here's another interesting relative income fact: A total household salary of $23,300 or below marked the lowest 20% of family incomes in 2013, according to the Federal Reserve. Meanwhile, your family would need to earn $154,600 to make it into the 90th percentile ranking in 2013:

Relative income distributions of U.S. households since 2001. Source: Federal Reserve consumer finances survey.

Why does it matter? Human beings are emotional and social creatures, rather than perfectly rational individual economic actors. That means that our behavior tends to be influenced not only by raw numbers, but also by what we see happening with those around us. If that weren't true, we'd never see stock market bubbles or panic selling.

The same idea applies to incomes. If one group of workers increases spending as their income rise, other groups may feel pressure to do the same, even if their earnings aren't improving at the same pace. This tendency to orient our self image as a function of others' positions is why relative income is such a useful economic concept.

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