consumption functions and theory

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economic consumption function and its theory





CONTENTS1.0 Consumption function and theory1.1 Keynesian Consumption function1.2 Relative Income hypothesis (RIH)1.3 Permanent Income hypothesis (PIH)1.4 Life Cycle hypothesis (LCH)1.5 Absolute Income hypothesis (AIH)2.0 Theory of Capital and Investment2.1 Meaning and types of Investment2.2 Marginal efficiency of capital2.3 The Present Value Concept2.4 The Interest rate2.5 Other factors that affect inducement to invest outside rate of interest.


1.1 KEYNESIAN CONSUMPTION FUNCTION:John Maynard Keynes (1936) was the first to evolve the concept of consumption function. According to him consumption function or propensity to consume refers to income consumption relationships. It is a functional relationship between two aggregates i.e total consumption and gross national income.Consumption demand depends on income and propensity to consume. Propensity to consume depends on various factors such as price level, interest rate, stock of wealth etc. constant in his theory of consumption. Thus with these factors being assumed constant in the short run, Keynesian consumption function considers consumption as a function of income. Thus we can represent the symbolical as C = F(Y)When C is consumption Y is income and F denotes functional relationship.Graphically we can represent this consumption function below:consumption


Fig 1.0C2



Figure 1 above shows a consumption function-denotary that consumption as a function of disposable income. Here consumption is a linear function based on the assumption that consumption changes by the same amount all through. The 45 line may be regarded as a zero saving line and shape and position of the C curve indicate the division of income between consumption and saving. It is important to note that the theory of consumption discussed here as propounded by J.M Keynes, according to him the main determinant of aggregate consumption expenditure is then aggregate level of income. This is often referred to as Absolute income Hypothesis. In a specific form, Keynesian function can be written asC = a + byWhere a and b are constant. While a is intercept term of the consumption otherwise known as Autonomous Consumption (Consumption of Zero level or no level of income), b stands for the slope of the consumption function and therefore represents marginal propensity to consume.We can illustrate the above expression graphically:Fig 2.0As = YC

C = a +by, = AEY > C

AS = Aggregation supplyAE = Aggregation expenditureEC


C >Y



From the diagram above the region denoted by a indicates autonomous consumption which is consumption at no level of income thus at this point such an economy is dissaving. When income is Zero output and hence aggregate expenditure is Zero. The higher the level of income the greater the national output and hence the greater the aggregate expenditure. All these stated above is represented by the 45 line. The point labelled E is the equilibrium level of income where AS = AEThere are some technical attributes of the consumption function there include:1. The Average Propensity to Consume:The Average propensity to consume may be defined as the ratio of consumption expenditure to any particular level of income. Algebraically, it is expressed as APC = C/Y Where APC = Average Propensity to Consume C = ConsumptionY = IncomeThe APC declines as income increases because the proportion of income spent on consumption decreases. Diagrammatically, the average propensity to consume is any one part the consumption curve as shown in the figure below.Consumption

Fig 3.0



Point E on the consumption curve above measure the Average propensity to consume. It pertinent to note that the APC declines as curve flattens to the right.2. The Marginal Propensity to Consume:The Marginal propensity to consume refers to the fraction of additional disposable income that is consumed. The concept is central to Keynesian economic analysis. The concept owes it origin to Keynes assertion that men are disposed as a rule and the average, to increase their consumption as their increases, but not by as much as the psychological law of consumption propounded by Keynes: according to which, as income increases consumption increases in income. Hence marginal propensity to consume is less than one.Summary we can say that the MPC is the ratio of the change in consumption to the change in income. It is expressed as MPC = C/ YRecall that marginal propensity to consume is less than one: thus1 > C/ Y > 0N:BThe MPC is constant at all level of income this is illustrated in the table below:INCOME YCONSUMPTION(C)APCC/YMPC C/ Y





Note: when income increases, the MPC falls but more than APC. On the other hand, When income falls, the MPC rises and the APC also rises but APC rises at a slower rate than MPC. This is possible during the cyclical fluctuations whereas in the short run there is no change in the MPC and MPC is less than APC. ( MPC < APC ). MPC is for short run analysis APC is for long run analysis

According to Keynes, there are two factors that determine and influence the consumption function. They can be classified as either objective or subjective factors. The subjective factors are Endogenous (internal) to the economic system they include Psychological characteristics of human natures, social practices and institutions and social arrangements.The objective factors on the other hand are exogenous: external to the economy itself. They may therefore undergo rapid changes and may cause marked shifts in the consumption function: they include: the level of income, income distribution, price level, availability of credit, fiscal policy etc.1.2 RELATIVE INCOME HYPOTHESIS (RIH): in 1949 An American economist James .S. Duesenberry put forward the theory of consumer behaviour which lay stress on relative income of an individual rather than his absolute income as a determinant of his consumption. According to Duesenberry, the consumption of a person does not depend on his current income level. This theory was based on ideals that were not considered in earlier economic analysis. These are1. That consumption behaviour of individual was influence by consumption behaviour of other individuals and2. That the consumption behaviour of individuals exhibits a ratchet effect deriving from the fact that consumption behaviour tends to be habitual: the habitual nature connecting that people try to maintain the standard of living they have become used to, the fact that they may have experienced a decline in income notwithstanding.Duesenberry posited that an individuals consumption and saving decision are influence by his social environment. Thus, given a level of income, an individuals is likely to consume more of that income if he lives in environment dominated by the well-to-do in society than if he lives in less affluent neighbourhood. Moreover efforts by the individual to maintain a certain economic status in his neighbourhood means that he spend more out of his income to maintain that status. Thus, his consumption, rather than being related to his absolute income level would be related to his relative income within his neighbourhood. This makes for a constant average propensity to consume given a relatively constant income distribution. Hence it makes for a proportional relationship between aggregate consumption and aggregate disposable income.Demonstration Effect: By emphasising relative income as a determinant of consumption, the relative income hypothesis suggests that individuals or households try to imitate or copy the consumption levels of their neighbours or other families in a particular community. This is called demonstration effect or Duesenberry effect. Two things fellows from this, First, the average propensity to consume does not fall. This is because of incomes of all families increase in the same proportion, distribution of relative income would remain unchanged and therefore the proportion of consumption expenditure to income which depends on relative income will remain constant.Secondly, a family with a given income would devote more of his income to consumption if it is living in a community in which that income is regarded as relatively low because of the working of demonstration effect. On the other hand, a family will spend a lower proportion of its income if it is living in a community in which that income is considered as relatively high because of demonstration effect will not be present in the case. For example, family with a given income say N500,000 per month spend a larger proportion of their income on consumption if they live in urban areas. The higher proportion to consume of families living in urban areas is due to the working of demonstration effect where families with relatively higher income reside whose higher consumption standards tempt others in lower income brackets to consume more.Duesenberry explains the social character of consumption pattern to mean the tendency in human beings not only to keep up with the Jenses but also to surpass the Jenses.Ratchet effect: in this regard, Duesenberry argued that people having become used to standard of living find it difficult to lower some even in the face of declining income. The second part of Duesenberry theory in the past part peak of income hypothesis while explains the short-run fluctuation in the consumption function and refutes the Keynesian assumption that consumption function relative are reversible. Here, once people reach a particular peak income level and become accustomed to this standard of living. They are not prepared to reduce their consumption pattern during a recession. Duesenberrys hypothesis are combined together into this formCt / Yt = a - b Yt/Yo

Where C and Y are consumption and income respectively.(t) Refers to current period(o) Refers to the previous peak(a) Is a constant relating to the positive autonomous consumption at#(b) Is the consumption function.In the above equation, the consumption function ratio in the current period ( Ct/Yt ) is regarded a function of ( Yt/Yo ) or the ratio of current income to the previous peak in income.GRAPHICAL ILLUSTRATION.The graph below illustrates Duesenberrys explanation of proportional / non-proportional relationship of consumption and disposable income.











The line LRCF is the long run consumption function, passing through the origin and therefore without an intercept guarantees the equality of MPC and APC. But the SRCFs are down to reflect the short run cyclical fluctuations which account for the drifts in the short run consumption functions. Thus given an while level of income Y0 consumption will initially be on the LRCF at point Y. This coincides with point Co on the vertical axis. A rise in income to Y1 will make an increase in consumption. But the movement will be along the short-run consumption function to point b. if the increase in income for Y0 to Y1 is persistent, the ratchet effect will hold and consumption will move up to point Z along the LRCF. This means an increase in consumption from C1 to C2 on the vertical axis. However, if consumers were to experience a decline in income to Y2, consumption would rather decline along the LRCF to point e fall along the SRCF, to point C. this is because consumption is still influence by his previous peak. The RIH suggest the following behavioural relationship between the APC and MPC depending on the direction of the change in income.a) If income is growing at a constant rate, APC would be constant with MPC equalling APC.b) If current income falls below a previous income level, the APC would be greater than the MPC.c) If income is rising but lags behind a previous income level the APC would be declining while the MPC would be rising but would nevertheless be less than the APC.d) If income is rising and it is above a previous level, the APC would be constant but would ensure the equality between MPC and APC.DEFECTS OF THE RIH A major defect of the RIH was its emphasis on the habitual behaviour and the demonstration effect arguments as the factors underlying consumption with the utility maximization assumption of the consumer as well as the rational behavioural assumption of consumers.1.3.THE PERMANENT INCOME HYPOTHESIS. (PIH)The permanent income hypothesis is found in Milton Friedmans famous study titled A theory of the consumption function published in 1957. According to Friedmans, permanent income is the amount a consumer unit could consume (or believes that it could) while maintaining wealth intact. While permanent consumption is the value of the services that it is planned to consume during the period in question.The permanent income hypothesis states that the ratio of the permanent consumption to permanent income is constant regardless of the level of permanent income.To friedman, the average propensities to consume may depend upon such factors as the ratio of interest, the ratio of non-human wealth to permanent income, the ages of members and the number of members in the consumers unit, the extent of income variability, etc. Notwithstanding the influence which these factors may exert on the individual consumer units consumption, the value of the consumption-income ratio is independent of the level of permanent income. The permanent income hypothesis can be set forth in terms of the following equations.CP=( i, w, u ) YpY=Yp+YiC= Cp+Yib ( Yp, YT ) = Ob ( Cp, CT ) = Ob ( YT, CT ) = O Where:Y = measured or observed disposable incomeC = measured or observed consumptionYp= permanent incomeYT= transitory incomeCP= permanent consumptionCT= transitory consumptionK = proportionality constant between permanent consumption and permanent incomeI = rate of interestW = ratio of non-human wealth to permanent incomeU = propensity of the consumer unit to add to consumption rather than to wealth. The most important factors which determine the value of U are the number ages of family members in the consumer unit and consumption i.e the extent of income variability and b = the correlation coefficient term.

Given t...