Shoujan sapkota

Consumption
It is defined as the part of income that is devoted on goods and services in order to derive
mental or physical satisfaction.
It is the use of economic resources to satisfy current human needs and wants.
The act of satisfying human wants is known as consumption.

Consumption function
➢ It is a functional statement of relationship between the consumption expenditure and its
determinants.
➢ Although the consumption expenditure of households depends on a number of factors—
income, wealth, interest rate, expected future income, lifestyle of the society, availability of
consumer credit, age and sex, etc.
➢ According to R.G. Lipsey, "Consumption function is nothing more than a statement of the
relationship between consumption expenditure and income”.
i.e., C = f(Y)
Where, C = Consumption, f = function, Y = Income
➢ If both disposable income and consumption change at a constant rate, consumption
function will be linear.
➢ In other words, if the slope of consumption curve remains constant through its length, it
is said to be linear.
i.e., C = a + bYd
Where, C=consumption function,
a = autonomous consumption,
b = slope of consumption function (marginal propensity to consume)
Yd = disposable income
 Technical Attributes of Consumption Function

The consumption function has two technical attributes.

1. Average Propensity to consume (APC):
➢ The average propensity to consume (APC) is defined as the relationship between total
income and total consumption.
➢ The APC may be defined as the ratio of consumption expenditure to income.
➢ It is the outcomes of consumption expenditure divided by income.
i.e. APC = C/Yd = C/Y
Where, APC = Average Propensity to Consume,
C = consumption expenditure,
Yd = disposable income
➢ Suppose, Yd = RS. 50,000 and C = 25,000, then APC = 25,000/50,000 = 0.5.
➢ It means that 50% of income is spent on consumption.
We know that,
Y=C+S
Dividing both sides of the equation by Y, we get,
Y/Y = C/Y +S/Y
1 = APC + APS, (0<APC<1)
APC = 1 – APS, (0<APS<1)
Properties of MPC
1. The value of MPC is always positive and less than unity. (i.e. 0<MPC<1)
2. The short run MPC is stable. Due to psychological and institutional factors.
3. The MPC of the poor is greater than that of the rich.

Figure: APC and MPC

 Relation between APC and MPC

1. APC is the ratio of absolute consumption to absolute income at a particular point of time.
MPC is the ratio of change in consumption to change in income.
2. If consumption function is linear: (a) APC is falling, while MPC is constant. (b) APC > MPC
3. If consumption function be linear passes through origin, both APC and MPC are equal and
constant.
4. If consumption function be non-linear; both APC and MPC decline with increase in income;
APC rises at a slower than MPC.

Income Consumption APC = C/Y MPC = ∆ C/ ∆ Y

0 50 - -
100 125 1.25 0.75
200 200 1 0.75
300 275 0.92 0.75
400 350 0.88 0.75
500 425 0.85 0.75

Factors Affecting Consumption Function

A. Subjective factors:
J. M. Keynes has highlighted the following subjective factors that determine the
consumption function.
1. Security motives:
People save in order to safeguard against unforeseen contingencies such as illness,
unemployment, accidents etc. These savings limit the consumption expenditure of
the society.
2. Speculation motives:
Some people want to save for investment in order to increase their future income. If
there are investment opportunities, the society save more. As a result, consumption
expenditure increases but on the other hand investment expenditure increases.
3. Social status:
People wish to save to accumulate wealth which will increase their social status. This
social behavior will decreases propensity to consume.
4. Thriftiness:
 Many people save because of their miserly instinct habits. The accumulation of more
wealth gives them a great psychic satisfaction.
5. Demonstration effect
Lower and middle income group imitate the consumption pattern of rich people and
this will increase their propensity to consume. This demonstration effect is an
important subjective or psychological force that leads to increase propensity to
consume.
6. Business motives
Many business firms desire to save to establish new firm and to expand the existing
firm. They save out from their current income for future contingencies and for
depreciation or replacement purposes.
B. Objective factors
Keynes has mentioned the following objectives factors which influence the consumption
function:
1. Distribution of national income: Consumption behavior of an economy is
influenced by both size and distribution of national income. Consumption is typically
the function of the poor and saving is typically the function of the rich. Therefore, in
a given national income, a more equal distribution of income will increase marginal
propensity to consume.
2. Fiscal policy: Taxation policy of the Government affects the propensity to consume
of the country. When the Government reduces taxes, consumption of the people
increases and this raises the propensity to consume and vice-versa. The indirect
taxes have more immediate effect on consumption them the direct taxes.
3. General price level: The general price level is an important determinant of
consumption function. Consumption expenditure decrease along with the increase in
price level and vice-versa
4. Rate of interest: According to classical economic theory consumption is regarded
as a negative function of the rate of interest. Other things remaining constant, real
consumption was inversely related to the rate of interest. But Keynes did not
regarded interest rate as a causative factor which significantly influences
consumption spending in the economy.
5. Credit Facility: The availability of easy credit leads to increases consumption
function. Consumer credit facility encourages the consumers to purchase durable
goods. The recent increased use of credit card and internet banking facility has
increased the consumption function in modern society.
6. Capital gains and Losses: When the prices of shares go up, the shareholders feel
better off than 6 before and spend more on consumption. But when the price of
shares go down, the shareholders feel worse off than before and reduces
consumption expenditure.
7. Future expectation: Future expectation such as inflation, war, shortage, epidemic,
natural disaster, political instability etc. encourage purchasing more. Similarly, when
the people expect that the price level is going to increases in near future, they start
additional purchases. As a result, consumption expenditure increases.
8. Wealth: The amount of wealth possessed by household is regarded as an
important determinant of consumption. According to law of diminishing marginal
utility as the stock of wealth increases, marginal utility of wealth diminishes. When
the size of wealth of individual increases, the desire to add further wealth decrease.
This leads to increase consumption function.

Psychological Law of Consumption Function

➢ J. M. Keynes propounded psychological law of consumption that forms the

foundation of consumption function.
➢ This law explains the nature of propensity to consume or nature of the functional
relationship between consumption and income.
➢ Law states that people have a tendency of spending less proportion of increased
income on consumption.
➢ According to J. M. Keynes, "The psychology of the community is such that when
aggregate real income increases, aggregate consumption also increases, but not
by so much as income."

Assumptions of Law

1. No change in the factors like desire, behaviour, fashion, population etc.

2. No government intervention.
3. Normal situation in the economy.
4. No change in price.

Three Propositions
The law is based on following propositions
Proposition I:
➢ When income increases, consumption expenditure also increases but by the smaller
amount because our wants get more and more satisfied along with the increase in
income.
➢ Marginal propensity to consume is less than one i.e. 1> ∆C/∆Y>0
Proposition II:
➢ The increased income will be divided in some proportion between consumption
expenditure and saving. i.e., ∆Y= ∆C+ ∆S
Proposition III:
➢ The increase in income results into an increase in both consumption expenditure
and saving.
 Income (Y) Consumption Saving (S=Y-C)
(C)

0 20 -20

60 70 -10

120 120 0

180 170 10

240 220 20

Proposition I: In the table, the amount of income increases at each state by Rs.60millions; but
the amount of consumption at each stage increases by Rs.50.
Proposition II: out of 60 million increases in income 50 million goes on consumption and 10
millions saved.
Proposition III: As income increases from 120 to 180, 240 ; consumption also increased from
120 to 170, 220 and saving increases from 0 to 10, 20 respectively.

In the figure, C = a + bYd is a linear consumption function with an intercept 'a'.Here, 'a'
represents autonomous consumption.
In the linear consumption function, the rate of change in income and the rate of change
in consumption both are constant. Therefore, the marginal propensity to consume is
constant.
However, average propensity to consume is falling with the increase in income.
It implies that, as income increase, a smaller proportion of income is spent on
consumption i.e. a larger proportion of income is saved.
 SAVING FUNCTION
• Saving is defined as the part of income not spent of consumption.
• It is the excess of income over consumption expenditure.
• The functional relationship between income and saving is known a saving function.
o Mathematically, S = f(Y)
• Where, Y = income, C = consumption, S = saving, and f = function

If both disposable income and saving change at a constant rate, saving function will be linear.
If the slope of saving curve remains constant through its length, it is said to be linear.
i.e. S = Y – C
= Y – (a + bYd)  c = a + bYd
= Y – a – bYd
= -a + (1-b)Yd
S = -a + sYd
Where, S= saving function,
a = autonomous saving,
s = slope of saving function( marginal propensity to save,
Yd = disposable income

Technical Attributes of Saving Function

The saving function has two technical attributes.

1. Average Propensity to saving (APS):
2. Marginal Propensity to Saving (MPS):
Average Propensity to saving (APS):
➢ The average propensity to saving (APS) is defined as the relationship between total
income and total saving.
➢ The APS may be defined as the ratio of saving expenditure to income.
➢ It is the outcomes of saving expenditure divided by income.
i.e. APS = S/Yd
Where, APS = Average Propensity to saving,
S = saving,
Yd = disposable income
➢ Suppose, Yd = RS. 50,000 and S = 10,000, then APS = 10,000/50,000 = 0.2. it means that
20% of income is saving.
Y=C+S
Dividing both sides of the equation by Y, we get,
Y/Y = C/Y +S/Y
1 = APC + APS, (0<APC<1) APS = 1 – APC, (0<APS<1)
 Marginal Propensity to Saving (MPS):

The MPS may be defined as the ratio of change in saving to change in income.
It is the outcomes of change in saving divided by change in income.
i.e. MPS = ∆S/ ∆ Yd
Where, MPS = marginal Propensity to save,
∆ S = change in saving,
∆ Yd = change in disposable income
Suppose, income increases from RS. 50,000 to 65,000 and saving increases from Rs 10,000,
to 15,000, then MPS = 5,000/15,000 = 0.33. it means that 33% of increased income is saved.
∆Y=∆C+∆S
Dividing both sides of the equation by Y, we get,
∆ Y/ ∆ y = ∆ C/ ∆ Y + ∆ S/ ∆ Y
1 = MPC + MPS, (0<MPC<1)
MPS = 1 – MPC, (0<MPS<1)

Income Consumption Saving APS MPS=∆S/ ∆ Yd

0 50 -50 - -

100 125 -25 -0.25 0.25

200 200 0 0 0.25

300 275 25 0.083 0.25

400 350 50 0.125 0.25

500 425 75 0.15 0.25

Relation between APC, MPC, APS and MPS

1. APC > MPC but APS < MPS

2. APC + APS = 1, if APC decreases APS increases with increase in income.
3. If autonomous consumption is zero, all values, i. e. APC, MPC, APS and MPS remain
constant, positive and less than one.
 Determinants of Saving
1. Level of income: Level of income is the main determinant of saving. Saving is directly
related with the level of income.
2. Distribution of National Income: If national income is distributed equally, it will be
favorable for the poor. Since, propensity to save is low for the poor, saving decreases and vice-
versa.
3. Rate of Interest: Like income level, rate of interest has positive relationship with saving. The
high rate of interest encourages the people of saving more.
4. Social Security: People save in order to safeguard against unforeseen contingencies such as
illness, unemployment etc. If the provision of social security such as free education, medical
care, unemployment allowances in the economy, people save less.
5. Fiscal Policy: When the government reduces the rate of direct tax such as income tax, it
will increase the saving. But if the government reduces the rate of indirect taxes, it will
encourage consumption which leads to decrease saving.
6. Price level: Price level is directly related to consumption and saving. When price level is
high, a larger pant of the income is spent on consumption. As a result, saving reduces.
7. Expansion of bank & financial institutions: Expansion of bank & financial institutions
encourage people to save more.

Paradox of Thrift (or Saving is a Vice, not Virtue)

➢ With regards to savings there are two different views; Classical and Keynesian
➢ According to classical view, saving is a virtue.
➢ Savings determine investment (i.e. S = f(I)) which plays a crucial role in increasing output &
employment.
➢ Believe that national saving is converted into the national investment. Again they assume
that saving and investment are equal (i.e. S = I)
➢ Saving determine investment which plays a crucial role in accelerating the rate of economic
growth.
➢ Keynes disagreed with the classical view and said saving is vice.
➢ Saving may be virtue for an individual from micro economic analysis because it helps to
accumulate personal wealth.
 ➢ But it is evil for the society because it reduces the national income and saving.
➢ An increase in saving leads to decrease consumption of the society.
➢ Decrease consumption leads to a decline profit, investment, output, employment and
ultimately decline in saving.
➢ Paradox of thrift refers to the situation of a decline in saving itself as a result of an attempt
to save more.

➢ SS is the initial saving curve & II is investment

curve. They are intersected at point E where
saving equals to investment.
➢ This equilibrium point determines OY level of
income.
➢ When the society try to save more, the saving
curve shifts up want from SS to S1S1.
➢ The new saving curve S1S1 cuts investment
curve II at point E1.
➢ This new equilibrium point determines OY,
Level of income.

Meaning of Investment and Investment Function

In the theory of income and employment, investment means an addition to the nation's
physical stock of capital like building machinery, raw materials, finished goods etc. Thus,
investment means the new expenditure incurred on addition of capital goods such as building,
machine, raw materials, tools etc. The new expenditure made on additional stock of physical
capital brings further increases in level of income and employment.
According to Edward Shapiro, "Investment is the value of that part of the economy's
output for any time period that takes the form of new structures, new producer's durable
equipment and change in inventories.
The classical investment function states that investment is the negative function of rate of
investment. It can be expressed as:
I = f(i)
Where, I = investment, i = rate of interest
The Keynesian investment function states that investment is the function of marginal
efficiency of capital and rate of interest. It can be expressed as:
I = f(MEC, i)
Where, I = investment, MEC = marginal efficiency of capital and i = rate of interest
 Types of Investment

1. Gross and Net Investment

Gross investment refers to total expenditure made on capital assets in a year. It includes
depreciation of capital stock. Net investment is gross investment minus depreciation.
In short, GI = NI + Depreciation
Or, NI = GI - Depreciation
2. Private and Public Investment
The investment made by private investors or entrepreneurs are called private
investment. It is influenced by marginal efficiency of capital (i.e. expected profit) and the rate
of interest. It is profit-elastic.
Public investment is made by the government on physical infrastructure, social services
etc. It has crucial role because it promotes social welfare of people.
3. Autonomous and Induced Investment
The investment, that is, independent of income in known as autonomous investment. Such
investment does not change with the change in the income level. So, it is income-inelastic. Generally,
autonomous investment is made by the government on development works, social services. It
depends more on population growth and technological progress.

In the figure, IIa is the autonomous investment curve which is a horizontal straight line. It
shows that whatever be the national income, investment remains constant at OI.
• The investment which varies with the change in national income is called induced
investment. It is income-elastic. As the level of income increases, aggregate demand for
consumption goods will increase. More investment has to be made on capital goods to
meet this increased demand. Thus induced investment increases with increase in
income and vice-versa.
• In the figure IId is the induced investment curve which is sloping upwards. It shows that
induced investment increases along with increase in income level and vice-versa

•
 Concept of MEC and investment demand curve

• The concept of marginal efficiency of capital was developed by J.M. Keynes as an

important determinant of investment in the economy. The marginal efficiency of capital
refers to the highest expected rate of return from an additional unit of capital assets
over its cost.
• According to J. M. Keynes, “The marginal efficiency of capital is equal to that rate of
discount which would make the present value of the series of annuities given by the
returns expected from the capital asset during its life just equal to its supply price.”
• To estimate the marginal efficiency of capital, the entrepreneur will take into account
the supply price or cost of new capital and its prospective yield.
1. Prospective Yield: The capital asset produces goods and gives income over its life time.
These yields take the form of a flow of money income over a period of time. The expected
yield (return) from investment on capital asset should be considered before investment. In
other words, an entrepreneur has to estimate the expected income of a capital asset over its
whole life.
2. Supply Price: The cost of the development or purchase of new capital asset is called the
supply price or cost of capital. In other words, the price which the entrepreneur has to pay for
a capital asset is called its supply price or cost of capital.
• Thus, the supply price and the prospective yields of a capital asset determine the
marginal efficiency of capital. The marginal efficiency of capital makes the present value
of the prospective annual yields of a capital asset equal to its cost. The discount rate is
used to convert the future yield into present value. The marginal efficiency of capital can
be obtained by using following formula.
• Supply price or Cost = Discounted Prospective Yield
or, C = R1/(1 + r) + R2/(1+r)2 + R3/(1+r)3 + ……+Rn/(1+r)n
Where, C = Supply price or cost of capital
R1, R2, R3………Rn = annual prospective yields.
r = rate of discount
• Here, rate of discount 'r' helps to make the annual prospective yields equal to the
supply price of the capital asset. Thus, 'r' represents the expected rate of profit for
marginal efficiency of capital.
• Example: Suppose, a capital asset costs Rs. 4000 rupees and its life is two years. Again,
suppose the expected yields of the machinery in the first and second year are Rs. 2200
and Rs. 2420 respectively. By using above formula we can calculate the value of
marginal efficiency of capital i.e r.
Supply price = R1/(1 + r) + R2/(1 + r)2
or, 4000 = 2200/(1 + r) + 2420/(1 + r)2
or, Thus, 10 percent rate of discount makes the prospective yield equal to the supply price
of the asset. So, 10 percent is the marginal efficiency of capital.
 Investment Demand Curve

This theory suggests investment will be influenced by:

1. The marginal efficiency of capital
2. The interest rates
Generally, a lower interest rate makes investment relatively more attractive.
• If the marginal efficiency of capital is more than the interest rate, the investment will be
justifiable.
• If the marginal efficiency of capital is less than the interest rate, the firm will not invest
on capital goods.
• If the marginal efficiency of capital is equal to the interest rate, the firm may or may not
invest on capital goods.

➢ The following table depicts clearly the relationship of

MEC and the rate of interest in the determination of
the inducement to invest:
• In this table, it is assumed that the new capital asset in
question gives a constant return of Rs. 1,000 annually.
The MEC and the rate of interest are given separately in
separate columns, having been determined
independently of each other. When MEC (4%), is equal
to the rate of interest (4%), the effect on investments is
neutral. When MEC is more than rate of interest, there
will be favorable effect on investment and when MEC is
less than the rate of interest, the effect on induced
investment is unfavorable.

• In the figure, investment is measured along x axis and

marginal efficiency of capital is shown in Y axis. Here, MEC
curve represents investment demand curve. Initially
when investment in capital asset is OI1, marginal
efficiency of capital is or1. As the investment increases to
OI2, marginal efficiency of capital decreases to or2 and so
on. Due to opposite relationship between investment and
MEC, the investment demand curve slopes downwards.
 Determinants of Investment
Broadly speaking inducement to invest depends on two factors viz. Marginal efficiency of capital
(expected rate of profit) and rate of interest. Out of these two determinant marginal efficiency
of capital is more important then the rate of interest because rate of interest is more or less
sticky (does not change much in short run). Even if the rate of interest is high if the expected
rate of profit is more that interest rate, it will induce investment.
1. Marginal efficiency of capital : The rate of profit expected from an extra unit of capital asset
is known as marginal efficiency of capital. The Supply price or cost of capital and the prospective
yields of a capital asset determine the marginal efficiency of capital. By deducting the supply
price from the prospective yield during whole life of capital asset we can obtain the expected
rate of profit or marginal efficiency of capital.
2. Rate of interest: The rate of investment is also depends on the rate of interest. When the rate
of interest is low, it will stimulate investment but the expected rate of profit should not be lower
than the rate of profit. Similarly, at higher rate of interest, the rate of investment will be low.
We can illustrate the determinants of investment in the following ways:
1. Short-run Factors:
a. Expected Demand for products: The volume of investment is large depends on expected
demand for goods & services. The expected demand for goods & services depends on several
factors such as propensity to consume, price level, taxation policy of the government, rate of
interest, business cycle, income level change in these factors leads to change in consumption of
households and demand for the products.
b.Propensity to Consume: The rate of investment MEC depends on propensity to consume.
When the propensity to consume is high, MEC & investment level will be high & vice- versa.
c.Price level: If there is tendency of increase in price level, the expected rate or return will be
high. It leads to increase the rate of investment.
d. Economic policy/Fiscal policy: The taxation policy adopted by the government can influence
the volume of investment. If the govt. adopts liberal economic policy, the level of investment
will be high and vice-versa.
e.Business cycle: At the time of optimism, the expected rate of returns will be high. In such
situation, the level of investment will be high. But at the time of pessimism, the expected rate
of returns will be low which leads to decrease the level of investment.
f.Income Level
As the income level increase it will increase the consumption expenditure. As a result, increase
in demand will stimulate investment level.
g.Cost of capital: The cost of capital influences the rate of return of capital. The cost of capital
depends on rate of interest, rate of depreciation, corporate income taxes. The lower rate of
interest, rate of depreciation and corporate income tax, the lower will be the user cost of capital.
This will increase the MEC and rate of investment.
Availability of credit: If the central bank adopts tight monetary policy, credit availability for
investment will be less. As a result, induced investment decreases. But if the central bank adopts
expansionary monetary policy, it will increase induced investment
2. Long-run Factors:
a. Growth of Population:
The aggregate demand for consumer goods (C) & capital goods (I) also depends on the
size and composition of population. As it increases, aggregate demand increases which in turn
increases the level of investment.
b. Technology and innovation:
The innovation of now technology and new product stimulates investment in new
capital goods. Advances in technology and new inventions make investment more productive.
As a result, the expected rate of return will be high.
c. Development of new sector:
As the government plans to develop new sectors, it will attract investment, huge
investment is required to develop new sectors to expand physical infrastructure.
d. New products:
Innovative entrepreneurs launch new products to earn abnormal profit in new market
attracts new firms which in turn increases investment level.
e.Situation of current Investment:
If the rate of investment in a sector is already too high, there will be less scope of new
investment. Generally, more investment is attracted by new areas and new products.

Principle of acceleration coefficient (Tabular explanation)

• Accelerator Theory of Investment or Acceleration Principle was first introduced by J.M.

Clark in 1917. Latter on economists like J.R. Hicks, P.A. Samuelson and R.F. Harrod
further developed this principle to explain business cycle.
• According to K.K. Kurihara, "The acceleration coefficient is the relation between induced
investment and an initial change in consumption. "
• It is important to note at the outset that the acceleration principle is concerned with the
size of the desired or optimum stock of capital rather than the change in investment.
• The acceleration principle describes the effect quite opposite to that of multiplier.
According to this, when income or consumption increases, investment will increase by a
multiple amount. When income and therefore consumption of the people increases, the
greater amount of the commodities will have to be produced.]
• This will require more capital to produce them if the already given stock of capital is fully
used. Since in this case, investment is induced by changes in income or consumption,
this is known as induced investment.
• The accelerator is the numerical value of the relation between the increase in
investment resulting from an increase in income. The net induced investment will be
positive if national income increases and induced investment may fall to zero if the
national income or output remains constant.
• J.R. Hicks has broadly interpreted the concept of acceleration principle. According to him, it is the
ratio of change in induced investment and change in income or output. Thus, symbolically

ii Assumptions
• The principle of acceleration coefficient is based on the
following assumptions:
• There is constant capital output ratio.
• There is no excess production capacity.
• Factors of production are homogeneous and perfectly divisible.
• There is no financial constraint and funds are easily available.
• Firms produce with the lease cost combination of inputs.
• Technology remains constant.
• There is absence of time lag.
• Factor market is competitive and factor prices are given.
• Firms' demand forecasting is accurate.

R must be deducted from the gross investment. Thus,