Unit-III

Consumption, Saving and Investment

Consumption Function: It is defined as the part of income which
is devoted on goods and services to satisfy human wants.
Consumption function refers to the general income consumption
relationship. It can be defined as the functional relationship
between total consumption and the total income. There is
positive relationship between income and consumption. It means
higher the income, higher is the consumption and vice versa.
According to A.H. Hansen "The consumption function shows
what changes can be expressed in the consumption from a given
change in an income."
According to R.G. Lipsey "Consumption function is nothing
more than a statement of the relationship between consumption
expenditure and income."
From the above definition it is clear that consumption function is
the functional relationship between consumption and income.
There is positive relationship between consumption and income.
The consumption function is expressed as;
C = f (Yd)
where,
C = consumption
Yd = Disposable income = (National income – Taxes)
It can also be written as;
C = a + bYd
where,
C = consumption expenditure
a = autonomous consumption
b = marginal prosperity to consume (MPC) (0<MPC<1)
Yd = Disposable income
The above equation of consumption shows that total
consumption is the sum of autonomous consumption and
induced consumption. Autonomous consumption is the
consumption at zero level of income and induced consumption
is determined by the level of income.
The concept of consumption function can be explained with the
help of given table and figure.
Consumption & Saving schedule (Rs in billions)
Income (Y) Consumption (C) Savings (S) = Y- C
0 40 -40
100 120 -20
200 200 0
300 280 20
400 360 40
500 440 60
Above table shows the income consumption and saving
schedule. When income is zero, consumption is Rs 40 billion
which is autonomous consumption. When income increases to
Rs 100 billion, consumption increases to Rs 120 billion. At
income Rs 200 billion, both consumption and income are equal.
When income increases above 200 billion both consumption and
saving will increases but saving will increase at the higher rate
than increase in consumption. When total income increase the
total consumption will also increase but at the lower rate than
the rate of increase in income. Before the income 200 billion
saving is negative which is dissaving. From the table above it is
clear that with the increase in income both consumption and
saving increase. It can be explained with the help of given
figure.
In the above figure, X axis represents income & Y axis
represents consumption. The consumption C is upward sloping
due to the positive relationship between income and
consumption. The 45˚ line shows that every point of income and
consumption are equal. The consumption curve 'C' and 45˚ line
intersect at the point 'E' which is known as the equilibrium point.
When income is Rs 200 billion, income and consumption are
equal. Before the income Rs 200 billion there is dissaving and
above the income level Rs 200 billion there is saving.

Types of Consumption function

1. Average Propensity to Consume (APC): It is the ratio
of aggregate consumption and aggregate income. It is
calculated by dividing consumption by income.
APC = C / Y
where,
APC = Average Propensity to Consume
C = Consumption
Y = Income
As income of the consumers increases average
propensity to consume will decrease. It can be explain
with the help of given table and figure.
Above table shows that consumption is increasing with
the increase in income but APC is decreasing with the
increase in income. When income is Rs 100 crore
consumption is also Rs 100 and APC is 1. Then it is
continuously decreasing. It can be explain with the help
of given figure.
In the above figure, X-axis shows the income and y-axis
shoes the consumption upward sloping curve CC
consumption curve. At income OY1, consumption is OC1.
When income increases to OY2, consumption increases to
OC2 and so on. But increase in consumption is less than
increase in income.
2. Marginal Propensity to Consume (MPC) : It is the ratio
of change in consumption to the change in income. It is
calculated by dividing change in consumption by the
change in income. It can be written as;
MPC = ΔC / ΔY
where,
MPC = Marginal Propensity to Consume
ΔC = Change in consumption
ΔY = Change in income
The concept of MPC can be explained by the help of
following table.
The above table shows that when both income &
consumption increase at constant rate MPC remains
constant. The table shows that MPC is constant by 0.8.
It can be explain by the help of figure.
In the above figure x-axis shows the income and y-axis
shows consumption. The upward sloping curve CC is
consumption curve. When income is OY1, consumption is
OC1. When income increases to OY2, consumption also
increases to OC2. The ratio of increase in consumption
(ΔC) and increase in income (ΔY) is MPC. It is a slope of
consumption curve. MPC is constant in short run.
Properties of MPC
 MPC is greater than zero but less than one : The value
of MPC is always greater than zero because
 consumption expenditure increases with the increase in
income but less than increase in income. So, Keynesian
psychological law of consumption can be stated as ;
0 <
MPC < 1 or, 0 < (ΔC / ΔY) < 1
 MPC of poor is greater than MPC of the rich : The poor
people spend a greater percentage of their income on
consumption than the rich people because the needs of
rich people are already fulfilled.
 The short run MPC is stable: The psychological and
institutional factors on which the propensity to consume
depends do not change in the short run. So short run
MPC is stable.
Relationship between APC and MPC
 APC is the ratio of total consumption to total income.
MPC is the ratio of change in total consumption to the
change in total income. So MPC is the rate of change
in APC.
 In figure A the consumption curve CC is straight line
with positive consumption expenditure at zero level of
income. In this situation APC is higher than MPC.
 In figure B OC is the long run consumption curve
which is passing through the origin. It means in long
run APC and MPC are equal.
 If consumption function is non linear both APC and
MPC decline but decline in MPC is more than APC
i.e. MPC < APC
Determinants of consumption function
1. Subjective Factors: These are the internal factors
which determine the consumption function. There are
two types of subjective factors and they are;
 Psychology of human nature
 Institutional arrangements

a. Psychology of human nature: There are seven

motives which lead the individuals to abstain from
spending out of their income. They are as follows;
 To build the reserve for unforeseen contingencies
such as death, diseases, etc.
 To provide for anticipated future needs such as
retirement, future higher studies of children, etc.
 To enjoy an enlarged future income by investing
funds out of current income.
 To be independence from other.
 To posses power or to get higher social and
political status.
 To secure enough funds to carry out speculation.
  To satisfy purely miserly nature.
b. Institutional arrangements: With respect to the
behavior of business corporations and government.
There are four motives for accumulation of money.
 Enterprise, i.e. the desire to expand business.
 Liquidity, i.e. the desire to face emergency easily.
 Rising income, i.e. the desire to demonstrate
successful management.
 Financial care, i.e. the desire to ensure adequate
financial provisions.

2. Objective Factors: The external factors which

determine the consumption function are objective
factors. The important objective factors are;
a. Change in wage level: The wage rate determines the
consumption function. If the wage rate rises, the
consumption function shifts upward. If the wage rate
falls consumption function shift downward.
b. Distribution of income: Distribution of income in the
society also determines the consumption function.
Greater the inequality of income distribution, lower
will be the propensity to consume and greater the
equality in income distribution higher will be the
 propensity to consume. More equal distribution of
income will raise consumption function.
c. Windfall gains and losses: It also affects the
consumption function. Windfall gains tend to raise
the propensity to consume, while windfall losses are
likely to shift the consumption function downward.
d. Fiscal policy: Changes in fiscal policy also affects the
propensity to consume. Increase in indirect tax,
rationing and price control adversely affects the
propensity to consume. Progressive taxation shifts
consumption function upward because it brings more
equality in income distribution.
e. Changes in expectations: The expectation of outbreak
of war, fear of shortage of goods and rising prices in
near future will induce the people to purchase more
goods which will shift the consumption function
upward.
f. Financial policies of corporations: Business policies
of the corporation with regard to income retention,
dividend payments and re-investment affect the
propensity of equity holders. If the corporation keep
more money in reserves and distributes less to
shareholders, it will reduce their income and
consumption function shift downwards.
 g. Holding of liquid assets: If people having the habit of
holding more money in their hand they will tend to
spend more out of their current income so their
propensity to consume will increase.
h. Attitude towards thrift: If the people regard saving as
a great virtue, they will tend to save more and
consume less which caused consumption function
will shift downward.
i. Social security: Making provisions of various social
security schemes, such as provident funds, life
insurance etc reduce the disposable income of the
people and consumption expenditure falls.
j. New Products: Introduction of new products in the
market leads to increase the consumption expenditure
which caused shift in consumption function upward.
Saving
Saving is the part of income that is not spent on
consumption. It can also be defined as the portion of
disposable income not spent on consumption of consumer
goods and services. It can be written as;
S=Y–C
where,
S = Saving
Y = Income
C = Consumption expenditure
Concept of saving function
The functional relationship between income and saving is
saving function. There is positive relationship between
income and saving. It means higher the income higher
will be the saving and vice versa. It can be written as;
S = f(Y)
since
S=Y–C
S = Y – (a + bY) ⸪ C = a + bY
S = Y – a – bY
S = -a + Y (1 – b)
S = -a + sY ⸪s=1–b
where,
S = Saving
Y = Level of Income
C = Consumption
s = Marginal propensity to save
b = Marginal propensity to consume
-a = saving at zero level
The relationship between saving and income can be
explained by the help of table and a figure below.

The above table shows that at income level zero and Rs

100 crore there is dissaving. When income is Rs 200 crore
saving is zero above income level Rs 200 crore there is
saving. It can be explained by the help of figure below.

In the above figure x-axis shows the income and y-axis

shows the saving and consumption. CC is consumption
curve and SS is saving curve. Both are increasing with the
increase in income. At income Rs 200 crore income and
consumption are equal. Below income level Rs 200 crore
consumption is more than income so there is dissaving.
Above income level Rs 200 crore income is higher than
consumption so there is saving.
Types of saving function
There are two types of saving function.
1. Average Propensity to save (APS): It is the ratio of
total saving to total income. It is expressed as;
APS = S / Y
where,
S = saving
Y = income
we know,
Y=C+S
Dividing both sides by Y we get
 y c s
= +
y y y
c
1 = APC + APS ⸪ APC = y

APS = 1 – APC

2. Marginal Propensity to Save (MPS): It is the ratio of

change of saving resulting from one unit change in
income. It can be defined as the ratio of change in
total saving to change in total income. It is expressed
∆S
as; MPS=
∆Y

where,
ΔS = change in saving
ΔY = change in income
we know that,
Y = C + S ………. i
Y + ΔY = C + ΔC + S + ΔS ……….ii
subtracting equation i from ii we get,
ΔY = ΔC + ΔS
Dividing both sides by ΔY we get
Δy Δc Δs
= +
Δy Δy Δy

1 = MPC + MPS
MPS = 1 – MPC
Investment Function
Investment is the part of income which is devoted on
purchase on those goods which are used for further
production of other goods to earn profit. The purchase of
shares, bond, and debentures is not investment because it
cannot increase the production of the economy.
According to D. Dillard "Investment is the addition to the
existing stock of real capital assets."
According to E. Shapiro " Investment is the value of that
part of the economy's output for any time period that takes
the form of new structure, producer's new durable
equipment and change in inventories."
The above definitions clear that investment is the part of
income which is spent to earn more income. There are
different opinions regarding investment function.
According to classical economists investment is the
function of interest rate, there is negative relation between
investment and rate of interest.
I = f (i)
where,
I = investment
i = rate of interest
According to Keynes investment is the function of rate of
interest (i) and marginal efficiency of capital (MEC).
Types of investment function
1. Gross investment and Net investment:
The total amount of expenditure made in new capital
goods during a year is gross investment. It includes
the depreciation value also.
Gross investment = Net investment + Depreciation
Net investment: If depreciation is deduced from the
gross investment then we can obtain net investment.
Net Investment = Gross investment – Depreciation
2. Induced investment and autonomous investment:
Induced investment: The investment that changes
with the change in national income is induced
investment. It is the function of income. It is written
as; I = f (Y). It can be explained with the help of
given figure.
 In the figure above x-axis represents income and y-
axis shows the investment. II is the investment curve
which slopes upward implies that investment
increases with the increase in income.
Autonomous investment: It is not affected by the
change in income. It is income inelastic. It is not
profit motive. It can be explain by the figure below.

In the above
figure x-axis
shows the
income and y-axis shows the investment. II is the
investment curve which is parallel to x-axis shows that
whatever the level income, the investment remains same.
3. Ex-ante investment and Ex-post investment: The
planned investment is known as ex-ante investment
and the actually realized investment is known as ex-
post investment.
 4. Private investment and Public investment : The
investment made by private sector to earn profit is
known as private investment. This type of investment
depends upon the MEC and rate of interest.
The investment made by the government sector to
provide maximum welfare to its citizens is called
public investment. Investment in construction of
roads, canals, hospitals, educational institution, etc. is
public investment.
Marginal efficiency of capital (MEC)
The expected rate of return from purchase of capital asset
is called MEC. This concept was firstly developed by
Irving Fisher MEC as the rate of return over cost. Later on
it was finally developed by economists J.M. Keynes.
According to Keynes any entrepreneur when investing on
new capital asset compares the expected rate of returns
with the rate of interest that will be required to be paid
when buying the capital assets. If the return is more than
interest rate that is required for payment then the
entrepreneur will be ready to invest in such a new capital
asset. The concept of MEC plays very important role in
business.
Determinants of MEC
1. Prospective yield: It is what an entrepreneur expects
to obtain from the output of its capital asset during its
lifetime. These yields take the form of a flow of a
money income over a period of time. The returns in
each year are called series of annuities represented by
Q1, Q2, ….., Qn. The prospective yield of a new
capital asset is the sum of the expected returns from
the capital asset during its lifetime.
2. Supply Price: The amount of money that any
entrepreneur invests on a new capital asset is known
as the supply price. It is also known as replacement
cost. After estimating the value of annuities and the
cost to produce necessary capital, asset, the investor
compares the expected returns with supply price.
This will give a rate which is called MEC. So the
MEC is the rate at which the prospective yield of a
capital asset is discounted to equal the supply price of
that asset. It can be expressed as;
Supply price = Discounted prospective yields
Q1 Q2 Qn
or, Sp = (1+r ) + (1+ r) + …+ (1+r )
1 2 n

where,
Sp = the supply price of the new capital asset.
Q1, Q2… Qn = the prospective yield in different years
1, 2… n.
 r = MEC or the rate of discount.

Q1
The term (1+r )
1 represents the present value of the
yield or annuity to be received at the end of the first
Q2
years discounted at the rate r. Similarly, the term (1+r )
2

presents value of the yield or annuity expected to be

received at the second year discounted at the rate r.
Ex. Assuming that the cost of capital assets is Rs 2000
and it gives net returns over two consecutive years as Rs
1100 and Rs 1210 and discount rate is 10%. Then the
present value of the net returns is given by;
Q1 Q2
Sp = (1+r ) + (1+ r)
1 2

1100 1210
or, Sp = (1+0.10) + (1+ 0.10)
1 2

or, 2000 = 1000 + 1000

⸫ 2000 = 2000
Hence, 10 % is the marginal efficiency of capital. The
investor compares the MEC with market rate of interest
and can make business decisions.
a. If MEC > Market rate of interest, the investor is
positive towards investment.
b. If MEC = Market rate of interest, he may or may not
choose to invest.
c. If MEC < Market rate of interest, investor is negative
towards the investment.
Investment demand curve
The investment behavior of an entrepreneur can be
explained with the help of schedule which is known as
MEC schedule or investment demand schedule. There is
an inverse relationship between MEC and investment so
the investment demand curve slopes downwards due to
diminishing MEC. There are two reasons for the
diminishing MEC, which are;
 As the volume of investment increases, expected annual
returns from capital assets falls due to the operation of
the law of diminishing returns.
 As volume of investment increases, the supply price of
capital assets will rise because of the increased demand
for machineries and equipment and the consequent rise
in their prices.
This can be explained with the help of given table and
figure below.

In the table above it shows the relationship between the

volume of investment and MEC. As investment increases
from Rs 5 billion to 10, 15, 20 and 25 billions, MEC falls
10% to 9%, 8%, 7% and 6% respectively.
Above figure shows the derivation of investment demand
curve. MEC slopes downward from left to right which
implies that as the capital increases, the MEC goes on
declining. The MEC curve depends upon the rate of
interest i.e. higher the rate of interest, the lower is the
investment and vice versa. In figure, at investment OI 1,
MEC is OR1. When investment increases to OI2, MEC
falls to OR2 and so on.
Determinants of Investment
There are short run and long run factors, which influence
the investment or MEC and are discussed below;
Short-run Factors
1. Expected demand: The MEC or investment largely
depends on the expected demand for products. If the
demand is expected to increase in future, the MEC will
be high and investment will increase and vice versa.
2. Cost and prices: If costs are expected to decline and
prices are expected to rise in future, the expectations of
investors about rate of returns from investment will go
up and cause rise in investment and vice versa.
3. Change in income: If the level of income of people
rises, the inducement to invest will increase. On the
other hand, the inducement to invest will fall with
lowering of income levels.
4. Propensity to consume: If the propensity to consume
is higher then to fulfill demand the investors will
increase investment. In other words, increase in
consumption will cause a similar increase in the MEC.
5. Current state of expectations: The current state of
business guides the investors to invest on new capital
assets. They estimate that the current situation of cost,
price, etc., will be same in future. Entrepreneurs often
invest on the assumption that the current state of affairs
will continue indefinitely.
6. Liquid assets: If there are large liquid assets with the
investors, the inducement to invest is high. But when
the assets are not liquid or there is shortage of working
capital, it often goes to inhibit new investment.
7. Government policy: If the government follows liberal
economic policy in the economy, it will have favorable
impact on investment. If the policy is tight then the
investors will be discouraged due to various
unnecessary burdens of taxes and so on.
8. Waves of Optimism and pessimism: In period
optimism, rate of profit or future investment are unduly
overestimated, while in period of pessimism they are
badly underestimated.
Long-run Factors
1. Growth of population: On increasing population,
investment will increase in all types of consumer goods
industries to fulfill the requirements. Similarly, a
declining population results in shrinking market for
goods and lowers the investment.
2. Development of new areas: For development of areas
it will need additional transport facilities, residential
and commercial buildings and so on which will lead to
heavy investment activities.
3. Technological progress: Progress on technological
activities will reduce costs and increase MEC. This
encourages the investors to invest in new capital assets.
The absence of new technologies will mean low
inducement to invest.
4. New Product: If the sale prospects of new product are
high and expected revenues are more than the costs,
MEC will be high, which will encourage investment in
related industries.
5. Development of industrial infrastructure: The
development of industrial infrastructure like
transportation, communication, electronics, banking,
insurance etc, increase the inducement to invest.
6. Rate of current investment: If the rate of current
investment in an industry is already high, there is no
scope for new investment in that industry unless the
demand is very high necessitating for new industries.
7. Rate of interest: The inducement to invest will be
higher if current market rate of interest to be paid at
present is lower than the expected rate of profit to be
received in future. If current rate of interest is higher,
the inducement to invest will be lower.

THE END