Consumption Function

Consumption Function
Propensity to consume is also called consumption function.  In the Keynesian
theory, we are concerned not with the consumption of an individual consumer but
with the sum total of consumption spending by all the individuals.  However, in
generalizing the consumption behaviour of the whole economy, we have to draw
some useful conclusions from the study of the behaviour of a normal consumer,
which may be valid for all consumers’ behaviour of the economy.  Aggregate
consumption depends on consumption function or propensity to consume.
The economic term ‘consumption’ means the amount spent on consumption at a
given level of income.  ‘Consumption function’ or ‘propensity to consume’ means
the whole of the schedule showing consumption expenditure at various levels of
income.  It tells us how consumption expenditure increases as income
increases.  The consumption function or propensity to consume, therefore, indicates
a functional relationship between the aggregates, viz., total consumption
expenditure and the gross national income.  It is a schedule that expresses
relationship between consumption and disposable income.
According to Keynesian theory, following are the factors that influence
consumption:
(a)    The real income of the individual,
(b)   The past savings, and
(c)    Rate of interest.
Average and Marginal Propensities to Consume:
The average propensity to consume (apc) is a relationship between total
consumption and total income in a given period of time.  In other words, apc is the
ratio of consumption to income.  Thus:
apc            =            C
                                 Y
Where  C            :            Consumption
              Y            :            Income
          apc            :            Average propensity to consume
While, the marginal propensity to consume (mpc) measures the incremental change
in consumption as a result of a given increment in income. In other words, mpc is
the ratio of change in consumption to the change in income.
mpc            =            ΔC
                                  ΔY
Where ΔC            :            Incremental change in consumption
             ΔY            :            Incremental change in income
           mpc            :            Marginal propensity to consume
the normal relationship between income and consumption is that when income
increases, consumption also increases, but by less than the increase in income.  In
other words, in normal circumstances, mpc is less than one.  It is drawn as a
straight-line with a slope of less than one. This slope indicates the percentage of
additional disposable income that will be spent.  It is assumed that the whole
additional income is not spent, i.e., a certain amount is spent and the remainder is
saved.  This can be further explained with the help of following table and diagram:
Income Consumption Saving
100 75 25
120 90 30
140 105 35
180 135 45
220 165 55

In the above diagram, OL is the income line and OP is income consumption

curve.  The income consumption line OP lies below the income line OL.  The mpc
will be measured by the tangent of the angle that income consumption curve makes
with X-axis.

The curve as we have drawn turns out to be straight line rising from the origin,
which means that mpc is constant throughout.  This, however, need not be so and
the curve may well become flatter as income rises, for as more and more
consumption needs have been satisfied, a greater share of an increase in income
than before may be saved.  The dotted curve OM represents such a relationship
showing that as income rises, mpc becomes smaller and smaller.
There is a level of disposable income (DI) at which the entire income is spent and
nothing is saved.  This point is often known as ‘point of zero savings’.  Below this
level of DI, the consumption expenditure will exceed the DI.  There may be cases in
which the consumer has no income at all.  In such cases, the income consumption
curve may not rise from the origin but from farther left showing that when income
is zero, consumption is not zero and that the individual is living on his past savings.
Propensity to Save:

In the above diagram, ON represents the saving-income curve.  Savings at a given

level of income can also be read off from the distance between a point on income-
consumption curve and corresponding point on income curve (See the figure of
income-consumption relationship). The marginal propensity to save (mps) can be
measured by the slope of income-saving curve ON.  Marginal propensity to save
(mps) is the increment in savings caused by a given increment in income.  The mps
is always equal to one minus mpc:
Keynes’ Law of Consumption:
Keynes propounded a law based on the analysis of consumption function.  This law
is known as ‘Fundamental Law of Consumption’ or‘Psychological Law of
Consumption’.  It states that aggregate consumption is a function of aggregate
disposable income.
Propositions of the Law:
This law consists of three propositions:
(a)    When aggregate income increases, consumption expenditure will also increase
but by a somewhat smaller amount.
(b)   When income increases, the increment of income will be divided in same
proportion between saving and consumption.  Consumption and saving go side by
side.  What is not consumed is saved.  Savings is, thus, the complement of
consumption.
(c)    As income increases, both consumption spending and saving go up.  An
increment in income is unlikely to lead either to less spending or less savings than
before.  It will seldom happen that a person may decrease his consumption or his
savings when he has got more income.
Assumptions:
(a)   Habits of people regarding spending do not change or that the propensity to
consume remains the same or stable.
(b)   The economic conditions remain normal.  There is no hyper-inflation or war
or other abnormal conditions.
(c)    The economy is a free-market economy.  There is no government intervention.
(d)   The important characteristic of the slope of consumption function is that
the marginal propensity to consume (mpc) will be less than unity.  This results in
low-consumption and high-saving economy.
Implications:
According to Keynesian theory, the mpc is less than unity, which brings out the
following implications:
(a)   Since consumption largely depends on income and consumption function is
more or less stable, it is necessary to increase investment fill the gap of declining
consumption as income increases.  If this is not done, the increased output will not
be profitable.
(b)   When the income increases, and the consumption are not increased, there is
a danger of over-production.  The government will have to step in to remedy the
situation.  Therefore, the policy of laissez-faire will not work here.
(c)    If the consumption is not increased, the marginal efficiency of capital
(MEC) will diminish.  The demand for capital will also diminish, and all the
economic progress will come to a standstill.
(d)   Keynes’ Law explains the turning points in the business cycle.  When the
trade cycle has reached the highest point of prosperity, income has gone up.  But
since consumption does not correspondingly go up, the downward cycle starts, for
demand has lagged behind. In the same manner, when the business cycle has
touched the lowest point, the cycle starts upwards, because consumption cannot be
diminished beyond a certain point.  This is due to the stability of mpc.
(e)    Since the mpc is less than unity, this law explains the over-saving gap.  As
income goes on increasing, consumption does not increase as much.  Hence saving
process proceeds cumulatively and there arises a danger of over-saving.
(f)     This law also explains the unique nature of income generation.  If money is
injected into the economic system, it will increase consumption but to a smaller
extent than increase in income.  This again is due to the fact that consumption does
not increase along with increase in income.
Factors Influencing Consumption Function:
There are certain factors affecting the propensity to consume in the long-run:
1. Objective Factors:
(a)   Distribution of income: It is generally observed that the average and marginal
propensities to consume of the poor are greater than those of the rich.  This is
because the poor has a lot of unsatisfied wants and he is likely to seize every
opportunity that comes his way to satisfy them.  On the other hand, the rich have
already a high standard of living and relatively less urgent wants remain to be
satisfied, so that in their case, an addition to their incomes is more likely to be saved
than spent on consumption.
(b)   Fiscal policy: Fiscal policy of the government will also influence the
consumption behaviour of an economy.  A reduction in taxation will leave more
post-tax incomes with the people and this will stimulate higher expenditure on
consumptions.  Similarly, an increase in taxes will depress consumption.
(c)    Changes in business expectations: Business expectations by affecting the
incomes of certain classes of people affect consumption function.
(d)   Windfall gains and losses: The windfall losses and gains arising out of
changes in capital values affect the ‘saving brackets’ mostly and not the spending
sections.  Hence, their influence on consumption function is not so well marked.
(e)   Liquidity preferences: Another factor is the people’s liquidity preferences.  If
people prefer to keep their income in liquid ford, consumption is reduced
correspondingly.
(f)     Substantial changes in the rate of interest.
2. Subjective Factors:
(a)   Individual motives to save:
(i)      Building of reserves for unforeseen contingencies as illness or unemployment,
(ii)    To provide for anticipated future needs such as daughter’s wedding, son’s
education, etc.
(iii)   To enjoy an enlarged future income by investing funds out of current income,
etc.
(b)   Business motives:
(i)      The desire to expand business,
(ii)    The desire to face emergencies successfully,
(iii)   The desire to have successful management,
(iv)  The desire to ensure sufficient financial provision against depreciation and
obsolescence.
Measures for Raising Consumption:
1.      Redistribution of income in favour of poor where propensity to consume is
greater.
2.      Comprehensive social security measures like unemployment doles, old-age
pension, sickness insurance, etc.
3.      Liberal wage policy, and
4.      Credit facilities for middle and poor classes for purchasing more consumer
goods.
Importance of Consumption Function:
1.      Important tool of macro-economic analysis.
2.      Value of the multiplier gives us a link between changes in investment and
changes in income.
3.      Consumption function invalidates the Say’s Law, which states that supply
creates its own demand, because this theory does not hold accurate in the real world.
4.      It shows the crucial importance of investment.
5.      It explains the reasons of declining MEC.
6.      It explains the turning points of business cycle.
Post-Keynesian Developments Regarding Consumption Function:
(a) The Ratchet Effect:
(i)                  Professor Duesenberry says that in matter of consumption, an
individual is not merely influenced by current income, but also by standard of living
in the past.
(ii)                The consumers are not easily reconciled to fall in their income.  They
try hard to maintain their previous standard of living.  This is to maintain their
position among their relatives, friends and neighbours.
(iii)             Consumption as a proportion of income goes up as income increases
and does not fall in the same proportion as the income falls. In other words,
consumption is not reversible.  This is known as ‘Ratchet Effect’.
(b) Demonstration Effect:
(i)                  The Duesenberry Hypothesis suggests that the consumer expenditure
depends on relative and not on absolute incomes.  The consumption function is
linear rather than curved because it is the income of a family relative to that of other
families.
(ii)                The ‘Demonstration Effect’ determines how much a consumer spent
and how much he saves.  Middle-class and poor people imitate the life style of rich
people.  People in under-developed countries try to follow the consumption pattern
of affluent nations.  This is called the ‘Demonstration Effect’, and it is dangerous as
it retards the economic growth.
(c) Pigou Effect:
(i)                    When prices fall as a result of a cut in money wages, the
purchasing power of money with a consumer increases, or there is an increase in the
real value of money.  People feel that they are now better off and they increase their
consumption expenditure.  This leads to expansion in GNP and has been referred to
as ‘Pigou Effect’.
(ii)                Keynes seems to be agreed that theoretically it is possible to bring
about full employment by sufficiently lowering the money wages. But the process
would be so slow that it could be ignored as a practical possibility.  It would be
more realistic to assume that wages are not so flexible (as assumed by Pigou) as to
permit the working of Pigou effect to bring about full employment.
(d) Government Consumption:
(i)                  Another factor which affects consumption and the level of economic
activity is the government expenditure.
(ii)                It differs from country to country and in the same country it differs
over time.
(iii)               Government may have a vital role in creating employment, influencing
consumption and adjusting saving through fiscal and other policies.
Theories of Consumption Function:
There are three different economic theories explaining consumption-income
relationship:
(a)   Absolute Income Theory: According to Keynes, on average, men increase
their consumption as their income increases but not by as much as the increase in
income.  In other words, the average propensity to consume goes down as the
absolute level of income goes up. Hence, according to this theory, the level of
consumption expenditure depends upon the absolute level of income and the
relationship between the two variables is non-proportionate.  However, it is pointed
out that although this relationship is one of non-proportionality, yet there is illusion
of proportionality caused by factors other than income, viz., accumulated wealth,
migration to urban areas, new consumer goods, etc.  Owing to such factors as these,
the consumers spend more and the relationship appears to be proportional.
(b)   Relative Income Hypothesis: The Relative Income Hypothesis was first
introduced by Dorothy Brady and Ross Friedman.  It states that the consumption
expenditure does not depend on the absolute level of income but instead the relative
level of income.
According to Dussenberry, there is a strong tendency for the people to emulate and
imitate the consumption pattern of their neighbours.  This is the ‘demonstration
effect’.  The relative income hypothesis also tells us that the level of consumption
spending is determined by the households’ level of current income relative to the
highest level of income earned previously.  People are then reluctant to revert to the
previous low level of consumption.  This is ‘ratchet effect’.
The relative income theory states that if current and peak incomes grow together
changes in consumption are always proportional to change in income.  That is,
when the current income rises proportionally with peak income, the apc remains
constant.
This proportionality relationship can be illustrated by the following diagram:

Income and consumption lines (Y and C) show proportional relationship, when

income grows steadily.  Similarly, if income grows in spurts and dips, the response
of the consumption is same.  Thus Y’ and C’ lines show proportional relationship.
(c)   Permanent Income Hypothesis: Friedman draws a distinction between
permanent consumption and transitory consumption. Permanent consumption stands
for that part of consumer expenditure which the consumer regards as permanent and
the rest is transitory.  Distinction can also be made between durable and non-durable
consumer goods.  Durable consumption is concerned with purchasing capital assets
and in the case of non-durable goods the act of consumption destroys the
good.  Ordinary consumer expenditure relates to non-durable consumption, i.e.,
consumption of goods which are quickly used in consumption.  These are
the ‘flow’items since a flow of them is being continuously consumed.  On the other
hand, durable consumption, which relates to the purchase of capital assets, is an act
of investment.  These are ‘stock’ items.
According to Friedman, permanent consumption (Cp) is a function of:
(i)            Rate of interest,
(ii)          Rates of consumer’s income from property and his personal effort, i.e.,
human and non-human wealth, and
(iii)         Consumer’s preference for immediate consumption multiplied by
permanent income (Yp).
The permanent income theory really emphasises the important role of capital assets
or wealth in determining the size of consumption.  It shows how both income and
consumption are closely linked with the consumer’s wealth.  It is capital and wealth,
which affects the level of consumption rather than consumer’s income.
(d)   Life Cycle Hypothesis: According to Life Cycle Hypothesis, the consumption
function is affected more by consumer’s whole life income rather than his current
income.  This view has been put forward by Modigliani, Brumberg and Ando.  The
permanent income hypothesis focuses attention on the income of the consumer
earned in recent past as well as expected future earnings (and wealth).  But the life
cycle hypothesis states the consumption function depends upon consumer’s whole
life income.  In childhood, the consumer earns nothing but spends all the same (his
parents spend on him); in the middle age, when he comes to have a family, he earns
and spends. But he will be earning more than he spends.  He tries to save enough to
maintain himself in his old age when he will not be able to earn or earn much.  Over
his life span, the consumer tries to maintain a certain uniform standard and with that
end in view he organises whole life’s uneven income flows of cash receipts.  In
other words, he will arrange his income and expenditure in such a manner as to
maintain a certain standard of living which he desires.
The ‘Life Cycle Hypothesis’ seems to be quite realistic and plausible.  It may be
noted, however, that this hypothesis emphasises income as derived from wealth
more than cash receipts.  It also draws our attention to the fact that the consumers
have to make a choice between immediate consumption and accumulating of assets
for future use.