Consumption Function

Consumption Function Theory of consumption function explain relationship

between consumption & income As per J.M Keynes, consumption expenditure of

household depends mainly on their current income Other factors influence like interest rate, taxation,

amount of wealth etc. As per Keynes, when income increases, consumption

increases but in a lesser proportion due to savings factor Consumption Function is also known as Propensity to

consume

APC & MPC Consumption function can be explained through

Average Propensity to Consume (APC) and Marginal Propensity to Consume (MPC)

APC – ratio of total consumption expenditure to total income

APC = C / Y i.e. Consumption / Income For instance, C = 60,000, Y = 1,00,000 APC = 60000 / 1,00,000 = 0.6 or 60% Household spends 60% of its income on consumption

APC & MPC MPC – Ratio of change in consumption to

change in income MPC = C / Y i.e. Change in Consumption

/ Change in Income Instance, change in C = 60,000 to 1,00,000 &

Y = 1,00,000 to 2,00,000 MPC = 40,000 / 1,00,000 = 0.4 or 40%

APS & MPS Counterparts of APC & MPC are APS & MPS APS – Average Propensity to Save MPS – Marginal Propensity to Save APS = S / Y (S = Savings, Y = Income) MPS = S / Y (Change in Savings / Change in

Income) APC +APS = 1 and MPC + MPS = 1 Rich people have more of MPS compared to poor MPC will be greater than MPS

Y C APC (C/Y)APS (S/Y)(1 –

APC)

MPC( C/ Y)

MPS ( S/ Y)(1-MPC)

1000 1000 1 0 - -

2000 1800 1800/2000 = 0.9 0.1 800/1000

= 0.8 0.2

3000 2500 2500/3000 = 0.83 0.17 700/1000

= 0.7 0.3

4000 3000 3000/4000 = 0.75 0.25 500/1000

= 0.5 0.5

5000 3200 3200/5000 = 0.64 0.36 200/1000

= 0.2 0.8

Factors Determining Consumption Function

2 types of Factors Objective Factors Subjective Factors – help in more saving

rather than spending hence consumption is reduced

Objective Factors Size of Income Price Level Distribution of

Income Propensity to Save Future Expectations Taste & Fashion

Rate of Interest Sudden Gains or

Losses Ownership of Assets Corporate Policy

(Dividend) Fiscal Policy Other Factors (Loans)

Subjective Factors Precaution against illness, accident,

unemployment etc. Future Expectations & Needs Accumulation of Wealth Independence Investment Speculation

Marginal Efficiency of Capital

Effective Demand J.M. Keynes emphasises on high level of

effective demand to maintain high level of employment

Effective Dem = Consumption Dem + Investment Dem

Consumption Demand Demand for final goods & services Depends upon level of income & propensity to

spend In Short run, it remains stable

Effective Demand Investment Demand

Demand for Capital Goods Depends upon rate of interest and marginal

efficiency of capital In short run, rate of interest is stable Marginal Efficiency of Capital is influential factor in

determining level of investment demand In short run, consumption demand remains stable

hence, level of employment is influenced by investment demand

Marginal Efficiency of Capital (MEC)

MEC is the expected rate of profitability from a capital asset

Rate of Return expected over & above the cost of an additional unit of capital asset

Capital Asset is brand new asset & not existing one Similarly, “return” is expected returns & not

existing returns or actual returns MEC depend upon prospective yield from capital

asset & supply price of the asset

Marginal Efficiency of Capital (MEC)

Prospective Yield From Capital Asset

Supply Price of

Capital Asset Total net return expected

from asset over its lifetime Net income received by

selling its output (products manufactured by machinery)

Net Income = Gross Income – Cost

Price of asset is considered before purchasing

Comparison is made between supply price & yield from the asset

Investment is made when yield is more than supply price

MEC According Keynes, MEC is the rate at which prospective

yield from a new capital asset to be discounted to make it equal to the supply price of the asset

Supply Price = 10,000 , Prospective Yield = 15,000 MEC = Price gap between them Formula to equalize prospective yield to supply price Cr = Q1/(1+r)1 + Q2/(1+r)2 + Q3/(1+r)3 ...... Qn/(1+r)n Cr = Supply Price of asset, Q1, Q2 = annual returns from

capital asset, r = rate of discount (marginal efficiency of capital)

MEC To find out r, formula can be rearranged as r = Q1 - 1 Cr For Instance, Supply Price = 1000 crore, Prospective yield for

1st year = 1250 crore r or MEC = 1250 / 1000 -1 = 0.25 or 25% When MEC is known and Prospective yield is to be calculated Cr = Q1 1000 = Q1 = 1250 (1+r)1 1+0.25 MEC and Interest Rate is compared, if MEC > Interest rate,

then investment project will be undertaken

Investment Demand Curve MEC curve slopes

downwards from left to right indicating inverse relationship between Investment & MEC

When more investment is made, prospective yield will decline supply price will rise

Questions 1. Explain the concept of consumption function 2. Differentiate between APC & MPC, APS & MPS 3. Throw light on the factors influencing consumption

function (Subjective or objective can come as short Note) 4. Sums to Calculate APC, MPC, APS, MPS will come 5. Discuss the concept of Effective Demand 6. Throw light on the concept of MEC with suitable diagram 7. Explain Investment Demand Curve 8. Sums to calculate MEC, Cr, Q will come