Theories of the Consumption Function 1

Theories of the Consumption Function - I

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Prof. Prabha PanthOsmania University,

Hyderabad

01/05/2023 Prabha Panth

Keynesian Consumption Function1. Absolute Income Hypothesis: Keynes’

consumption function based on Psychological Law.

• Not based on empirical data.• Short run analysis.• Y C , but < Y . • C = a + bY, where a is autonomous C, and b is

MPC.• According to Keynes, MPC is constant.• But APC falls as Y increases.

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C, S

Y

C=a+bY

MPC = slope of C-function. Is constant

Y=C+S

0

APC =slope of radius vector. Falls as Y increases

Keynesian Consumption Function

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Empirical Consumption Function• Keynes assumed that:

– Current absolute C is related to current Y.– C-Y relationship is reversible – consumers will

increase C when Y increases, and decrease C when Y decreases.

– Consumer’s C-patterns are determined autonomously. That is, consumers’ C is independent of other’s C.

– APC as Y, and – MPC remains constant as Y.

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Kuznet’s Paradox

• Empirical data does not entirely support Keynes’ C-function.

• Simon Kuznets: showed that behaviour of APC and MPC were not the same for the short run,

• and long run consumption functions,• And for cross section and time series data.

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• Kuznets’ empirical analysis:– Time series data showed APC is constant for

the long run (1889-1938 USA data), around 0.8.

– Therefore MPC = APC.– But for Cross section data, or short run,

APC falls and APS increases, as Y increases, • This is called Kuznet’s Paradox.• Different economists tried to explain this

empirical puzzle,

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II. Relative Income Hypothesis• J.S. Duesenberry’s theory of Relative

Income.– Consumption is relative to other’s C, as well

as to relative Y.– Depends on a person’s position in society,

compared to others.– C is irreversible over time, as Y C will not fall

at the same rate. – Consumers want to maintain their old

standard of living

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C = a + bYt + bYt-1

According to Duesenberry (cross section data):

• If one person’s Y, and Ys of all others also increase at the same rate, then C – function shifts upwards.

• Relative position will not change and there will be no change in consumers’ C/Y.

• This means APC and APS remain constant.

• Supports Kuznet’s findings of empirical analysis.

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C, S

Y0

Y=C+S

C1

A B

A1

B1 C2

DUESENBERRY’S RELATIVE INCOME HYPOTHESIS

When Y and C of both A and B increases at the same rate, then C-function shifts upwards, and APC of both remain constant.

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• But if a consumer’s Y increases > others, then his APC more than others.

• Relative income hypothesis suggests that HH try to imitate the C of their neighbours.

• This is called the “Duesenberry effect” or the “demonstration effect.”

• He also suggested that C levels are irreversible downwards.

• When Y, C will not fall at the same rate. So APC, when Y

• This is called the “Ratchet effect”

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C, S

0Y

C

Y1

C1

Y0

C0

When Y falls to Y0, C also falls, but APC increases. This is the Ratchet Effect.

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Education

Theories of the Consumption Function 1