Consumption Function
It is a functional relationship between two aggregates i.e., total consumption and National Income. Consumption is an increasing function of income
Symbolically C= f (Y)
Consumption Schedule
It is the tabular representation of various amounts of consumption expenditure corresponding to different levels of income.
TableTable 1:1: ConsumptionConsumption ScheduleSchedule
IncomeIncome ConsumptionConsumption 00 2020 6060 7070 120120 120120 180180 170170 240240 220220 PropertiesProperties ofof thethe ConsumptionConsumption FunctionFunction
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.
Expressed as percentage or proportion of income consumed.
APC= C/Y
APC declines as income increases because the proportion of incomeincome spentspent onon consumptionconsumption decreases.decreases.
APS = 1- APC MarginalMarginal PropensityPropensity toto ConsumeConsume It is defined as the ratio of change in consumption to the change in income. It is the rate of change in APC. MPC= ∆C/ ∆Y. MPS=1-MPC Significance of MPC Over the long run APC and MPC are equal and approximate 0.9. MPC is assumed to be positive and less than unity which means that consumption is an increasing function of income and it increases by less than the increase of income. Economic significance of the MPC lies in filling the gap between income and consumption through planned investment to maintain the desired level of income.income. Keynes’sKeynes’s PsychologicalPsychological lawlaw ofof ConsumptionConsumption
ThisThis lawlaw sayssays “that“that menmen areare disposeddisposed asas aa rulerule andand onon thethe averageaverage toto increaseincrease theirtheir consumptionconsumption asas theirtheir incomeincome increasesincreases butbut notnot byby asas muchmuch asas thethe increaseincrease inin theirtheir income”.income”. Three related Propositions 3. When Income increases, consumption expenditure also increases but by a smaller amount. Thus, it increases less than proportionately. 4. The increased income will be divided in some proportion between consumption expenditure and saving. 5. Increase in income always leads to increase in both consumption and saving. Table:Table: 22
Income(Income( Y)Y) Consumption(Consumption( SavingsSavings (S)(S) C)C) 00 2020 -20-20 6060 7070 -10-10 120120 120120 00 180180 170170 1010 240240 220220 2020 300300 270270 3030 AssumptionsAssumptions
ItIt assumes assumes a a constant constant Psychological Psychological and and InstitutionalInstitutional complex complex which which means means that that income income distribution,distribution, tastes, tastes, habits, habits, social social customs, customs, price price movements,movements, populationpopulation growth,etcgrowth,etc remainremain constantconstant andand consumptionconsumption dependsdepends onon income.income. ItIt assumesassumes thethe existenceexistence ofof normalnormal conditions.conditions. TheThe lawlaw does does not not operate operate in in abnormal abnormal conditions conditions like like war,war, revolutionrevolution oror hyperinflation.hyperinflation. ItIt assumes assumes the the existence existence of of lassiez-Fare lassiez-Fare Capitalist Capitalist economieseconomies and and is is in in operative operative in in case case of of socialist socialist economies.economies. DeterminantsDeterminants ofof ConsumptionConsumption FunctionFunction SubjectiveSubjective factorsfactors (( endogenousendogenous oror internalinternal toto thethe economiceconomic system).system). 2. PsychologicalPsychological characteristicscharacteristics ofof humanhuman nature.nature. 3. SocialSocial practices.practices. 4. BehaviourBehaviour PatternPattern ofof BusinessBusiness concernsconcerns 5. SocialSocial arrangementsarrangements affectingaffecting distributiondistribution ofof income.income. OnOn thethe basisbasis ofof aboveabove characteristicscharacteristics therethere cancan bebe individualindividual asas wellwell asas BusinessBusiness Motives.Motives. ObjectiveObjective FactorsFactors
1. ChangesChanges inin wagewage level.level. 2. WindfallWindfall GainsGains oror losses.losses. 3. ChangesChanges inin thethe FiscalFiscal Policy.Policy. 4. ChangeChange inin Expectations.Expectations. 5. ChangeChange inin RateRate ofof interestinterest 6. FinancialFinancial policiespolicies ofof Corporations.Corporations. 7. DistributionDistribution ofof IncomeIncome 8. AttitudeAttitude towardstowards SavingSaving 9. DuesenberryDuesenberry HypothesisHypothesis MeasuresMeasures toto raiseraise thethe PropensityPropensity toto ConsumeConsume
IncomeIncome RedistributionRedistribution IncreasedIncreased WagesWages SocialSocial SecuritySecurity MeasuresMeasures CreditCredit FacilitiesFacilities AdvertisementAdvertisement DevelopmentDevelopment ofof thethe MeansMeans ofof TransportTransport UrbanisationUrbanisation TheoriesTheories ofof consumptionconsumption FunctionFunction
Relative Income Hypothesis is given by James Duesenberry. Based on two assumptions: A) Consumption behaviour of an individual is not independent but interdependent on other individual. B) Consumption Relations are irreversible and not reversible in time. AccordingAccording to to Duesenberry Duesenberry human human beings beings not not onlyonly try try to to keep keep up up with with joneses joneses but but try try to to surpasssurpass the the joneses joneses which which shows shows that that consumers’consumers’ preferences preferences are are interdependent. interdependent. RichRich people people will will have have a a lower lower APC APC and and poorpoor peoplepeople willwill havehave higherhigher APCAPC butbut inin longlong runrun APCAPC willwill remainremain constant.constant.
AccordingAccording to to Duesenberry Duesenberry it it is is harder harder for for a a familyfamily toto reducereduce itsits expenditureexpenditure fromfrom aa higherhigher levellevel thanthan forfor aa familyfamily toto refrainrefrain fromfrom makingmaking highhigh expendituresexpenditures inin thethe firstfirst place.place. • The outcome of this statement is that as income falls consumption declines but proportionately less than decrease in the income because the consumer dissaves to sustain consumption.
• Duesenberry combines his two related hypothesis in the following form
Ct/ Y t = a-b Yt /Yo Where C --- Consumption Y--- Income t ----Current time period o ---- Previous Peak a ---- positive autonomous consumption b---- Consumption Function • InIn thisthis equation,equation, thethe consumptionconsumption incomeincome ratioratio inin thethe currentcurrent periodperiod isis regardedregarded asas functionfunction ofof ratioratio ofof currentcurrent incomeincome toto thethe previousprevious peakpeak income.income. • RatchetRatchet effecteffect isis aa peculiarpeculiar phenomenonphenomenon observedobserved inin thisthis case.case. TheThe shortshort runrun consumptionconsumption functionfunction ratchetratchet upwardsupwards whenwhen incomeincome increasesincreases inin thethe longlong runrun butbut itit doesdoes notnot shiftshift downdown toto earlierearlier levellevel whenwhen incomeincome declines.declines. CriticismCriticism
ProportionalProportional relationshiprelationship betweenbetween consumptionconsumption andand incomeincome isis notnot alwaysalways true.true. ItIt neglectsneglects otherother factorsfactors thatthat influenceinfluence ,, consumerconsumer spendingspending suchsuch asas assetasset holdings,holdings, urbanisation,urbanisation, appearanceappearance ofof newnew products,products, etc.etc. ExpectationsExpectations andand levellevel ofof aspirationsaspirations alsoalso playplay anan importantimportant rolerole inin consumerconsumer spending.spending.