Consumption Function(1)

7/29/2019 Consumption Function(1)

1/24

1

Consumption Function

Consumption function or propensity to consume isfirst and important component of effective demand.

Effective Demand: effective demand represents theactual expenditure on consumption and investment atany equilibrium level of employment.

This shows the total demand for goods and servicesin the economy.

The concept of consumption function is illustrated byKeynes with the heading, Keynes PsychologicalLaw of Consumption.

The concept of consumption function in generaltheory is based on the psychological tendency withregard to consumption.


2/24

2

According to Keynes, the volume of consumptiondepends upon the size of income.

There is a stable functional relationship between

total income and consumption, this relationship iscalled Propensity to Consume or Consumptionfunction, and Shown as:

C = f(Y)

It shows there is a functional relationship between thetotal consumption and total income.

Thus, the propensity to consume refers to the actualexpenditure on consumption at various levels ofincome.

It demonstrates that when income increases,consumption also increases but not to the sameextent as the increase in income.


3/24

3

According to Keynes: The psychology of the

community is such that when aggregate real

disposable income is increased, aggregate

consumption is increased, but not by so much as

income.

Proposition of Keynesian Law of Consumption:

The law has three interrelated propositions:(i) With the rise in income, consumption expenditure also

rises but by a smaller amount than the income. This is

because as income rises more and more our wants get

satisfied.(ii) The rise in income is distributed between consumption

and savings.

(iii) An increase in income therefore always results rise in

consumption and savings.


4/24

4

Assumptions of the Law:

(a) Stability of the consumption function is derived from

constant psychological and institutional complex. It means

factors like income distributions, habits, tastes, customs,population which influence consumption expenditure do

not change.

(b) Normal conditions are assumed to be present. The law

does not operate under abnormal conditions like war and

inflations.

(c) It assumes the existence of a laissez-faire capitalist

economy.

With these assumptions the law is a rough approximation

to the actual behaviour of consumers and operates in the

short period of time.


5/24

5

Propensity to Consume: A Schedule

(Rs. In Crores)

Income (Y) Consumption (c) Savings (S)

100

200

300

400

500

120

200

280

360

400

-20

00

20

40

100


6/24

6

From the schedule, when consumption amounting

to Rs. 120 crores,it exceeds the income of Rs. 100

crores, which may be met by past savings or from

borrowings.

That suggests the minimum expenditure on

consumption in the economy initially may exceed

the income.When consumption expenditure equals the income

at Rs. 200 crores, it is called the break-even point.

Beyond this point, as income rises, consumption

expenditure does not keep pace with the increase in

income.

This situation can also be shown by the diagram as

follows:


7/24

7

C2

C1

C

Y1 Y2

B

S2

S1

S3

S

X

Y

O

S

C

consumption

Income

Y=C

s4


8/24

8

The above chart shows how the total income isdistributed among the consumption expenditure andsaving.

Curve CC represents the consumption function orpropensity to consume.

At OY1 Income, the consumption expenditure ismore than the Income and at point B the

consumption expenditure OC1 is equal to OY1,which shows the break-even point.

As the income rises to OY2, the consumptionexpenditure is OC2, but the consumption is lessthan the income, i.e. C1C2 < Y1Y2.

Hence, the portion of income S1S2 is saved by thecommunity and this is how the consumption functionshows the amount of money saved.


9/24

9

The saving curve SS is also derived from theconsumption function.

It shows that when income is less than OY, saving is

negative.At the break-even point, saving is zero and beyond

this saving increases with increase in income

It can be seen from the graph that at OY2 income,saving is S1S2 = S3S4.

It is clear from the above analysis that given thepropensity to consume, the income is derived

between consumption and saving, i.e. Y = f (C, S).But the important aspect is that the proportion of

income devoted to consumption, which in turninfluences the level of income and employment.


10/24

10

Average Propensity to Consume (APC):

APC is the ratio of total consumption to the total

income, i.e.APC = C/Y

The nature of APC is that it declines as income

increases, because the proportion of income spent

on consumption decreases.

That means the gap between Y and C widens, i.e.

the average propensity to save increases as income

increases.This can be better understood by the help of a

figure shown below:


11/24

11

X

Y

A

B

C

C

O

80

90

100 120

Income (Rs.)

Consumption (Rs.)


12/24

12

The figure shows the average propensity to consume at

any one point on the consumption curve CC.

The CC curve is made up of a series of such points andall such points represent the propensity to consume at

different levels of income.

At point A, the APC is 80/100 = 80%, and when income

rises from 100 to 120, the consumption also increasesfrom 80 to 90, i.e. APC at point B is 90/120 = 75%.

It shows, the total consumption increases when the

income increases, but the proportion of income devotedto consumption declines with the increase in income.

Thus, the flattering of the CC curve to the right shows

declining APC.


13/24

13

Marginal Propensity to Consume (MPC):

The concept of MPC is considered as an essential

part of general theory of employment.As we know, consumption expenditure is considered

as important determinants of employment, output

and income.

So, the MPC shows that additional employmentdepends on additional consumption when income

rises.

Hence, the concept of MPC is important to createthe employment in the economy.

MPC: Its is the ratio of the change in consumption to

the change in income, symbolically:


14/24

14

MPC = C/ YWhere, C refers to change in consumption and Y

refers to the change in income.Value of MPC: it is obvious that neither will all the

incremental income be consumed, not will it beentirely saved.

If the entire incremental income is consumed then,MPC = C/ Y = 1, and

If, on the other hand, no portion of incremental

income is consumed, then MPC =

C/

Y = 0However, in reality, some portion of incremental

income will always be consumed. It means that thevalue of MPC will be greater than zero but less than

unity, i.e. MPC >0 but < 1.


15/24

15

From the MPC, we can derive the marginal propensity to

save (MPS), i.e.

MPS = 1- MPC or 1 - C/ Y MPC can be shown diagrammatically as:

Y

X

Y

C

90

80

100 120

C

C

A

B

O

Consumption (Rs.)

Income (Rs.)

MPC


16/24

16

The figure shows, when income rises by Rs. 20/-,consumption increases by Rs. 10/-.

Hence the MPC = C/ Y, i.e. 10/20 = 0.5 or 50%

Which shows, the MPS is also 50%. Hence, the marginal propensity to consume is measured

by the slope of the CC curve.

Relationship Between APC and MPC:

The analysis of APC and MPC shows that

(a) Both decline with an increase in income

(b) But, the decline in MPC is greater than the decline inAPC.

It is the case of rich communities because most of theirbasic needs have already been fulfilled. As a resultadditional income is saved and the MPS rises.

The whole analysis shows that as the real income of thecommunity increases, the consumption also increases but

less than the increase in income.


17/24

17

Factors Determining the Consumption Function:

(a) Subjective or Internal or Endogenous factors

(b) Objective or External or Exogenous factors The subjective factors determine the slope and position of

the consumption function, where as the objective factors

determine the shifts in the consumption function, as

illustrated by:

O Y Y1

C

C1

C

C

Y

X

Y

X

C

C

Y

C2

C3

O

Fig: a Fig: b


18/24

18

Figure (a) shows a change in consumptionexpenditure because of change in income with nochange in propensity to consume.

Where as figure (b) illustrates the change inconsumption expenditure caused by changes in thepropensity to consume keeping income constant.

Subjective Factors in the Consumption Function:

The subjective factors can be grouped into threeclasses, such as (a) Psychological characteristics ofhuman nature, (b) Institutional patterns and (c)Social practices.

(a) Psychological Factors:

There are certain psychological motives whichencourage savings and reduce consumption of the

household. There are 8 motives in this group:


19/24

19

(i) Motive of Precaution: Which encourages savings to

meet unforeseen emergencies in future.

(ii) Motive of Foresight: Reserves are built to cover

anticipated future needs such as old age.

(iii) Motive of Calculation: the desire to enjoy interest.

(iv) Motive of improvement: the desire to enjoy the

gradually increasing income.(v) Motive of Independence: The desire enjoy a sense

of independence.

(vi) Motive of enterprise: the desire to establish a

business project.(vii) Motive of pride: the desire to possess and bequeath

wealth.

(viii)Motive of avarice: the desire to satisfy miserliness.


20/24

20

(b) There are certain factors which encourageconsumption such as:

Generosity, short-sightedness, enjoyment,

miscalculation, extravagance etc.(c) There are certain factors which encourages

savings in corporate sectors, such as

(i) Motive of Enterprise: the desire to acquireresources to carry out further investment.

(ii) Motive of Liquidity: The desire to cope up withemergencies successfully.

(iii) Motive of Financial Prudence: to makesufficient financial provision against depreciation.

This shows the psychological and institutionalfactors determines the decisions whether to

consume or save.


21/24

21

Objective Factors in the Consumption Function:

There are some important factors which causes

shift in the consumption function in the community.

These are as follows:

(a) Fiscal Policy: the budgetary policy of the

government relating to taxation, publicexpenditure, public debt, etc., will have significant

effects on the consumption function.

Example: Imposition of heavy taxation, diversion ofresources during Second World War have

depressed the consumption function below its

normal condition.


22/24

22

(b) Changes in the Rate of Interest:Substantial changes in the rate of interestalso alter the propensity to consume. If therate of interest rises significantly, people willconsume less and save more in order to gainfrom the higher rate of interest.

(c) Changes in Expectation: the expectationregarding future changes especially changesin prices and supply affect to consumptionfunction. This leads people to purchase

goods much in excess of current needs. As aresult, the ratio of consumption to currentincome will rise and thereby cause upward

shift to consumption function.


23/24

23

(d) Windfall gains or losses: The rapid changes in the

capital value which occur in the stock market, may

increase consumption function.

Example:Recent boom in the stock market has increasedthe consumption in the hands of people.

(e) Changes in Price Level: this affects in a negative way.

A rise in price level reduces the real income in hands of

people and hence, they buy less with more money.

(f) Distribution of Income: if there is great inequality in

the distribution of income, it lowers the overall propensity

to consume. The rich people have low marginalpropensity to consume as they have already fulfilled

most of their basic wants. A more equal distribution of

wealth through fiscal measures by the state will raise the

propensity to consume.


24/24

24

(g) Duesenberry Factors: Prof. Duesenberry has

given two important factors affecting the

consumption function, as:

(i) Past standard of Living: the consumption

expenditure of an individual depends on the

current income and the standard of living enjoyed

by him in the past. Suppose income falls, theexpenditure on income falls less as people fail to

make adjustment.

(ii) Demonstration Effect: this shows the

consumption standards of low income groups areinfluenced by the consumption standards of the

high income groups. In this case the propensity to

consume increases out of a given income.

Documents

Consumption Function(1)