THE THEORY OF CONSUMPTION

It should be noted that the largest component of Aggregate demand is the level of consumption.

A. CONSUMPTION

Consumption is the total expenditure by households, firms and the government on goods and
services which gives or yields the same level of satisfaction in the current period at the prevailing
price. The amount an individual spends on goods and services will be determined by the
following factors;

i. Level of Income
ii. Taste and Fashion
iii. Level of Enjoyment
iv. Articles of Ostentation
v. Change in the distribution of Income
vi. Price

CONSUMPTION FUNCTION

The consumption function is any equation, table of graph showing the relationship between
consumers dispensable Income (Yd.) i.e. Y-T and the amount of goods and services the
consumer desired or demanded.

According to Lord Maynard Keynes ‘he assumes that the rate of consumption is directly or
linearly related to the rate of disposable income.

c = a + b Yd

a
Intercept

Income Level

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If we assume that there is no government intervention there will be no need for the rate of taxes.

That is, National Income becomes

Y = C + I, where C = a +bY

a = autonomous expenditure (does not depend on income) I = Investment, C = level of

consumption, b = marginal propensity to consumers (MPC) meaning that part of consumption
that depends on income.

∆C
cons ∆Y

Therefore, a and b are constants.

MARGINAL PROPENSITY TO CONSUMER (MPC)

The M.P.C is the fraction of an additional income that will be consumed, the letter ‘b’ is the
MPC which is the ratio of a change in consumption to a change in income ∆ C/∆ Y. But in a
governed economy, the dispensable income is the National Income – Taxes,

That is Yd = Y – T
C = a + bYd
Y = a + bYd
Y = a + b(Y - T)
Y = a + bY - bT
The slope of the consumption functions is the letter ‘b’ or MPC. Another concept of the
consumption function is the average propensity to consume.

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THE AVERAGE PROPENSITY TO CONSUME:

This is fraction of disposable income that is consumed i.e C/Yd. It is also expressed as the ratio
of consumption to the disposable income. Given, the following figures calculate the National
Income Equilibrium Level.

C = a + bY + I.

Where a = 20b, b = 0.8, I = 20b

To find the equilibrium level of income.

Y=C+I
C=a+b
Y = a + bY + I
Y - bY = a + I
Y (1 + b) = a + I
Y=a+1
(1 – b)

20 + 20 = 40
1 – 0.8 0.2

₦200b.

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 B. SAVINGS

The individuals or business firms can use their income in 2 ways namely, consumption and
savings.

Savings is that part of income that is not consumed or spends in the current year. More precisely,
saving is the different between income and consumption. It follows that

S=Y–C

Where S = Savings, Y = Income and C = Consumption.

Therefore, we can obtain the savings function by using the equation

C = a + bYd

We can derive savings as;

S = Yd – C ………………….(i)

S = Yd – (a + bYd) ………….(ii)

S = Yd – a – bYd …………… (iii)

Collect the like terms

S = Yd – bYd – a ……………..(iv)

S = - a + Yd – bYd ……………(v)

S = -a + Yd (1 – b) ……………..(vi)

From equation (vi) we have derived the savings function, which is the mirror image of the
consumption function.

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 Y
Savings
b = ΔS
ΔY

+
O Income level
-
a Interception

SAVINGS FUNCTION

The saving function shows the relationship between savings and disposable income. The quantity
(1-b) is the marginal propensity to save, that is, (MPS) which is the fraction of additional income
that is save. Alternatively, (MPS) is defined as a change in savings to a change in the disposable
income or the ratio of the change in savings to the ratio of change in the disposable income. This
∆s
relationship can be expressed as MPS =
∆ Yd

Note that the slope of savings function is (1-b).

Another concept of the savings function is the Average Propensity to Save (APS).

The APS is defined as the fraction of dispensable income that is saved, which is symbolically
written as; APS = S/Yd.

Since any additional income that is not spend will be saved.

Then MPC + MPS = 1.

To proof this; MPC = b and MPS = 1 – b, if MPC+MPS = 1

b+1–b=1

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So, since the addition of

MPC and MPS = 1. Then, we can say

MPC = 1 – MPC
and
MPC = 1 – MPS
The argument above is also applicable to APC and APS
If APC = 1 – APS
Then APS = 1 – APC.

C. DETERMINANTS OF PROPENSITY TO CONSUME

The propensity to consume refers to the likelihood or inclination of individuals or households to
spend their income on goods and services rather than saving it. Several factors influence an
individual's or household's propensity to consume. These determinants include:
1. Income Level: The most significant determinant is income. Generally, as income rises,
people tend to consume more. However, the relationship between income and
consumption may not be linear, and as income increases, the marginal propensity to
consume (MPC) may decrease, meaning that a smaller portion of additional income is
spent.
2. Wealth and Assets: Accumulated wealth and assets can also influence consumption.
Individuals with significant savings, investments, or valuable assets may have a lower
propensity to consume because they feel financially secure and don't need to spend their
entire income.
3. Interest Rates: The prevailing interest rates can affect consumption decisions. Lower
interest rates on loans and credit cards can encourage borrowing and spending, thus
increasing the propensity to consume. Conversely, higher interest rates may discourage
borrowing and lead to higher savings.
4. Consumer Confidence: People's perception of the future economic conditions, job
security, and overall financial well-being can impact their willingness to consume. When
consumers feel optimistic about the economy, they are more likely to spend.

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 5. Government Policies: Government policies such as tax rates, social welfare programs,
and stimulus measures can influence consumption. Tax cuts or direct cash transfers, for
example, can boost disposable income and encourage spending.
6. Cultural and Social Factors: Cultural norms, societal expectations, and peer pressure can
also affect consumption patterns. People may spend more to keep up with their peers or
meet social expectations.
7. Personal Preferences: Individual preferences, values, and goals play a significant role in
determining consumption behavior. Some people prioritize saving for the future, while
others prefer immediate consumption.
8. Economic Expectations: Expectations about future inflation, income growth, and job
prospects can impact consumption. If people anticipate higher inflation, they may
increase their spending to preserve the purchasing power of their money.
9. Credit Availability: Easy access to credit, such as credit cards and loans, can influence
spending behavior. When credit is readily available, individuals may be more inclined to
consume beyond their current income levels.
10. Demographics: Age, household size, and family composition can affect consumption
patterns. For example, younger individuals and families with children may have higher
consumption needs.
11. Economic Shocks: Unforeseen events like recessions, natural disasters, or health crises
can significantly impact the propensity to consume. During economic downturns, people
may reduce spending due to uncertainty and financial strain.
12. Saving Goals: Personal financial goals, such as saving for retirement, education, or a
major purchase, can influence consumption decisions. Individuals with specific saving
goals may allocate a smaller portion of their income to consumption.

Therefore, these determinants interact in complex ways, and an individual's propensity to

consume is the result of various factors working together. Economists and policymakers often
study these factors to understand and predict consumer behaviour, which, in turn, can have
important implications for economic growth and stability.

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 D. KEYNES THEORY OF CONSUMPTION
John Maynard Keynes, a prominent economist of the 20th century, developed a comprehensive
theory of consumption that was a significant departure from classical economic thought. Central
to his theory of consumption is the concept of the "psychological law of consumption."

Keynes's Theory of Consumption:

Keynes's theory of consumption is outlined in his magnum opus, "The General Theory of
Employment, Interest, and Money," published in 1936. This theory challenges the classical
economic view that people save a consistent portion of their income and consume the rest.
Instead, Keynes argued that consumption decisions are influenced by various psychological and
economic factors, resulting in fluctuations in overall demand.

1. Aggregate Demand: Keynes believed that the level of aggregate demand in an economy
was a critical determinant of economic activity. He argued that fluctuations in aggregate
demand, particularly during economic downturns, could lead to unemployment and
economic instability.
2. Marginal Propensity to Consume (MPC): Keynes introduced the concept of the marginal
propensity to consume (MPC), which represents the proportion of any additional income
that people will spend on consumption. He contended that the MPC is not constant but
rather varies with changes in income levels. When income increases, people tend to save
a smaller portion of the additional income and consume more, leading to a multiplier
effect on overall demand.
3. The Consumption Function: Keynes formulated the consumption function, which depicts
the relationship between disposable income and consumption. According to Keynes, the
consumption function is not linear; instead, it exhibits diminishing marginal propensity to
consume. This means that as income increases, the MPC decreases, and people save a
larger portion of their income.

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KEYNES’S PSYCHOLOGICAL LAW OF CONSUMPTION:
The psychological law of consumption, proposed by Keynes, states that as income increases,
people tend to consume more but not proportionally. Instead, the rate of increase in consumption
is less than the rate of increase in income. This leads to a higher savings rate as income rises.
Keynes illustrated the psychological law of consumption with the concept of the "propensity to
consume" and the "propensity to save." He argued that as income rises, individuals tend to
consume a smaller fraction of the increase in income and save a larger fraction. This reflects the
idea that people have a natural inclination to save part of their income, especially when they feel
financially secure. In summary, Keynes's theory of consumption and the psychological law of
consumption challenged classical economic ideas by emphasizing the role of psychological
factors and variability in consumption behavior. According to Keynes, changes in income do not
lead to proportional changes in consumption, and understanding these non-linear relationships is
crucial for managing economic stability and addressing periods of unemployment and economic
recession. Keynes's ideas had a profound impact on macroeconomic policy and laid the
foundation for modern macroeconomics.

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