CHAPTER 4: CONSUMPTION FUNCTION:

4.1 Introduction:

The consumption function describes the functional relationship that exists between income and

consumption. An increase in income results in an increase in consumption but less than

proportionately. In other words, consumption is an increasing function of income.

C=F ( Y )

It is to be noted that consumption will take place even at zero income level. This is because

everyone has basic needs that need to be fulfilled and in order to fulfil such needs, they will turn

to past saving or in other words, dissave in order to maintain their consumption level.

This dynamic can be explained using a consumption schedule.

INCOME CONSUMPTION

0 20
60 70
120 120
180 170
240 220
300 270
360 320

The above table tells us that a zero level of income, the individual consumes 20 units of his

income. Here income does not refer to the regular inflow of income but saving. The individual is

dissaving in order to maintain his basic consumption level. When income increases from 0 to

60, consumption increases from 20 to 70. Up until this point, the individual is consuming more

than what he/she can earn. Which means, there is not a single unit of the increment of income

that is being saved. In fact, it is being dissaved. This is because the consumer is trying to fulfil

his “basic” necessities of life which have up unit now remained unfulfilled because of the lack of
a regular stream of income. Income increases from 60 to 120, which increase consumption from

70 units of income to 120 units of income. Which means all units of income are spent on

consumption expenditure. There are no savings or dissaving at this point. At this point, the

person has most likely fulfilled his basic needs and comforts. After this point, income increases

from 120 to 180 and consumption increases from 120 to 170. Its noteworthy to note that

consumption is smaller than income. Income then increases to 240 and consumption increases

to 220. It can be seen that while consumption is smaller than income, consumption increases

less than proportionately with an increase in income. This trend continues to remain the same

for the various increments of income. This theory is known as the Keynesian Psychological

Law of Consumption.

In the above figure, income is represented on the x-axis while consumption and saving are

represented on the y-axis. The 45-degree line, also known as the zero-saving line or income line,

represents income while the ‘C’ curve represents the consumption curve. The consumption curve

cuts the income line at equilibrium point B, where income is OY1. Before point B, the individual

spends more than they consume. They dissave to satisfy their private wants. As income increases

gradually to OY1, the negative gap between income and consumption begins to decline. At point

B the individual spends all units of income on consumption expenditure. Savings at this point

are not negative, but zero. When income increases from OY1 to OY2, consumption also increases
but less than proportionately from BY1 to SY2. This is because as income increases the individual

begins to save more and more of his income, as indicated by S1S.

4.2. Propensities to consume:

4.2.1 Average propensity to consume:

The average propensity to consume tell us how much of his/her income does an individual

spend on the consumption of goods and services. It tells us the fraction or portion of income

spent on consumption.

C
APC=
Y

The average propensity to consume decreases with an increase in income. This is because as

income levels begin to increase, less and less portion of income is spent on maintaining a basic

consumption level. From this, it can be inferred that the APC of a rich person would be relatively

lower compared to the APC of a poor person.

APC=1−APS

The complement of APC is APS. i.e., average propensity to save. The average propensity to save

tells us how much of income does a person save. The relationship between APS and income is

the complete opposite of that of APC and income. Higher the income levels, higher the amount

of income that is saved.

When income levels are greater than consumption, APC < 1, and when consumption levels are

greater than income, APC >1. However, APC can never be zero. This is because even when

income levels are zero, people continue to consume. APC although, can be equal to 1. This is

because it is not unthinkable for a person to spend all units of their income on consumption of

goods and services.

APC is diagrammatically represented in Panel A in the below figure.

4.2.2. Marginal propensity to consume:

The marginal propensity to consume (MPC) tells us how much of a change in income results in a

change in consumption.

∆C
MPC=
∆Y

Lower the income levels, higher will be the marginal propensity to consume and vice versa. This

is because rates of change are much more elastic at lower levels of income than its opposite. The

change in consumption from zero-income levels to the bare minimum will be high compared to

the change in consumption due to a change in income from a millionaire to a trillionaire. This is

because the latter has abundant savings, which will most likely make a changes in consumption

more inelastic to change in income.

Consequently, the marginal propensity to consume of a rich person will be lower than the

marginal propensity to consume of a poorer person. The MPC is diagrammatically represented

in the above diagram in Panel B.

It can be arithmetically calculated as,

MPC=1−MPS
MPC and MPS have an inverse relationship. The marginal propensity to save tells us how much

of a change in come results in a change in savings. Higher the MPC of a person, lower their MPS

and vice-versa.

The marginal propensity to consume fluctuates between 0 and 1. However, it can never be

negative. This is because rates of change can never be negative.

1 ≥ MPC ≥0

4.3. Theories of Consumption Function:

4.3.1. The Absolute Income Hypothesis:

The Absolute Income Hypothesis is the econometric representation of the Keynesian

Psychological Law of Consumption. In other words, this theory states that consumption increase

but less than proportionately with an increase in income.

C=a+ bY

Where,

a. C = consumption

b. a = intercept, consumption levels when income is zero

c. b = slope/ mpc, which measures the change in consumption due to the change in income

d. Y = income
This is diagrammatically represented in the above figure. Income is represented on the x-axis

while consumption is represented on the y-axis. The 45 ° line represents income while the ‘C’

curve represents the consumption function. The 45 ° line cuts the C curve at equilibrium point E0

where income is OY0 and consumption is OC0. when income increases from OY0 to OY1

consumption also increases from OC0 to OC1. From the above diagram it is clear that the change

in consumption is lesser than the change in income. In Keynes’ words, “consumption increases

but less than proportionately with an increase in income.”

There are 4 major points to be noted about the theory:

1. It states that MPC fluctuates between 0 and 1.

2. It states that APC > 1 when income levels are lower than consumption and APC < 1 when

income levels are greater than consumption.

3. This theory states that people spend part of their income on consumption and partly on

savings and it is for this reason that consumption increases less than proportionately

with an increase in income.

4. This theory is stable both in the short-run and long-run.

4.3.2. The Drift Theory of Consumption:

The drift theory of consumption was developed by Arthur Smithies and James Tobin. According

to Smithies and Tobin, empirical studies revealed that while the Keynesian Psychological Law of

Consumption proved to be accurate in the short-run, consumption was noted to be proportional

to income in the long-run.

They identified the following 7 factors that lead to the proportionality of consumption to income

in the long-run.

1. Increase in Asset holdings: People with more assets have been found to have large

spending habits in comparison to those who don’t. This is because an increase in asset

holdings results in an increase in gains or returns in the form of liquid money. This in

turn increases consumption levels in the long-run.

2. Urbanisation: Urbanisation generally involves the transitioning of an agrarian area into

an industrialised economy almost always resulting in the new mushrooming of

industries, population explosion in tight squalors, large economic and social

infrastructure building etc. Urbanisation increases investment levels which ultimately

result in an increase in income levels. This in turn, increases consumption.

3. Age distribution: Each generation in different economies behave differently. They have

spending habits that are in stark contrast to one another. Therefore, consumption levels

also depend on the demographic dividend of the economy. For example, Indians of the

1980s generally have a larger propensity to save than to spend. But an Indian born in the

2010s might have a hard time reconciling with saving. If latter kind constituted the

majority of the workforce, consumption levels would increase in the economy.

4. New products: When new products are introduced into the economy, they make their

former versions obsolete. This results in an increase in the purchase of the current

technology with spikes an increase in consumption levels.

 5. Decline in saving motive: We know that part of income is spent on consumption

expenditure and part of it is spent on saving. A decline in saving motive indicates that

there is a larger portion of income that is available for consumption expenditure which

increases the average propensity to consume of the individual.

6. Consumer credit: Consumer credit allows a person to consume goods and services that

are beyond his/her means. This creates a faux amount of disposable income that allows

the individual to increase their consumption levels.

7. Expectation of Income Increasing: When individuals become aware that they are going

to receive income soon, it allows them to splurge a bit more than they usually do because

they know that they aren’t going to run out of money anytime soon. Therefore,

consumption levels increase with an increase in income.

This is represented in the above diagram. Income is represented on the x-axis while

consumption is represented on the y-axis. CL represents the consumption line in the long run

whereas CS2 represents consumption line in the short-run. The CS2 curve cuts the CL curve at

equilibrium point A. When income increases CS2 ‘drifts’ to become CS1. Consumption levels

increase along the CL curve to point B proportionately in the long run due to the above-

mentioned factors.

This theory was criticised on the following grounds:

 1. The theory did not mention the numerical rate at which CS2 curve shifted to become the

CS1 curve. i.e., they were no mathematical estimations to back up this rate.

2. According to James Dusenbery, the factors that were mentioned above were not

significant enough to shift the CS2 curve to CS1 curve.

4.3.3. The Relative Income Hypothesis:

The Relative Income Hypothesis was introduced by James Dusenbery. He had propounded his

theory on two major hypothesis:

a. Consumer preferences were not independent: He had opposed Keynes’ statement

that consumer preferences were independent in nature. According to Dusenbery,

According to Duesenberry’s relative income hypothesis, consumption of an

individual is not the function of his absolute income but of the consumption levels of

his neighbours. In other words, people purchase things that are of equal or higher

social status of their neighbours purely out of a social need. For example, A rich man

would spend a small portion of his income to fulfil his consumption needs whereas a

relatively poor man would spend a larger portion of his income trying to maintain the

same level of consumption. In other words, the APC of a rich man would be low while

that of the relatively poor man would be high. This provides the explanation of the

constancy of the long-run APC because lower and higher APCs would balance out in

the aggregate.

Thus, according to James Dusenbery, consumer preferences were highly

characteristic of the demonstration effect.

 b. The Ratchet Effect: According to James Dusenbery, an increase or decrease in

consumption levels were highly dependent on business cycles and income levels. He

advocated that during times of boom, when income levels increase, consumption

levels also increase proportionately. However, during times of depression, while

income levels regressed back to their previous level, consumption levels do not

regress back to its previous levels but decrease less than proportionately. This is

because people have become accustomed to a certain standard of living due to which

they are unable to settle down for lower standards of living. When the economy

enters the recovery period, income levels again increase. But consumption levels only

increase proportionately slowly. This is because the individual is unable to restore his

savings back to its original level quickly. This pattern when plotted on a graph looks

like a ratchet and henceforth, named as the ratchet effect.

James Dusenbery combined his two hypothesis to create the Relative Income Hypothesis.

The relative income hypothesis is explained graphically in Fig. 4 where CL is the long-run

consumption function and CS1 and CS2 are the short-run consumption functions. Suppose income

is at the boom period level of OY1, where E1Y1 is consumption. Now income falls to OY0. Since

people are used to the standard of living at the OY1 level of income, they will not reduce their

consumption to E0Y0 level, but reduce it as little as possible by reducing their current saving.

Thus, they move backward along the CS1 curve to point C1 and be at C1Y0 level of consumption,

instead of regressing back to E0Y0 consumption levels. When the period of recovery starts,

income rises to the previous boom period level of OY1. But consumption increases slowly from

C1 to E1 along the CS1 curve because consumers can only slowly restore their previous level of

savings.
If income continues to increase to OY2 level, consumers will move upward along the CL curve

from E1 to E2 on the new short-run consumption function CS2. If another recession occurs at

OY2 level of income, consumption will decline along the CS2 consumption function toward

C2 point and income will be reduced to OY1 level. But during recovery over the long-run,

consumption will rise along the steeper CL path till it reaches the short-run consumption

function CS2. This is because when income increases beyond its present level OY1, the APC

becomes constant over the long-run. The short-run consumption function shifts upward from

CS1 to CS2 but consumers move along the CL curve from E1 to E2.

But when income falls, consumers move backward from E2 to C2 on the Cs2 curve. These upward

and downward movements from C1 and C2 points along the CL curve give the appearance of a

ratchet. This is the rachet effect. The short-run consumption function ratchets upward when

income increases in the long run but it does not shift down to the earlier level when income

declines. Thus, the ratchet effect will develop whenever there is a cyclical decline or recovery in

income.

The theory was criticised on the following grounds:

1. It unrealistically assumed that consumption increased proportionately with an increase

in income, when actually consumption increased less than proportionately with an

increase in income.
 2. It advocated that consumer preferences of an individual were a function of their

neighbour’s consumption patterns, which is empirically proved not to be the case for

most consumers.

3. It stated that consumer preferences were irreversible over time. According to Michael

Evants, consumer preferences could actually be reversible over time slowly.

4. He assumed a linear relationship between consumption and income which was not the

case. Consumption can increase due to many other factors besides income.

5. The Ratchet effect propounded by James Dusenberry was actually the Reverse Lightning

bolt effect due to its zig-zag consumption patterns that highly resembled a lightning

bolt’s mirror-image.

4.3.4. The Permanent Income Hypothesis:

The permanent income hypothesis was introduced by Friedman, the father of the monetarist

revolution. Friedman agreed with the Keynesian statement that consumption does not increase

proportionately with an increases in income. He however also acknowledged the fact that

consumption increased proportionately with an increase in income, in the long run. He

propounded the Permanent Income Hypothesis to explain the proportionately characteristic of

consumption to income in the long run.

Dr. Friedman had introduced permanent and transitory characteristics to consumption and

income. i.e., income or measured income could be broken down into permanent and transitory

income and consumption or measured consumption could be broken down into permanent and

transitory consumption.

Permanent income referred to the flow of income to a particular household whose wealth

remained intact even after consumption. In other words, it’s the main source or stream of
income of a family. Transitory income on the other hand, referred to income flows that were

unexpected or irregular such as windfall gains.

Ym=Yp+ Yt

When transitory income is positive, measured income is greater than permanent income. When

transitory income is negative, measured income is lesser than permanent income. When

transitory income is zero, measured income is equal to permanent income.

Permanent consumption on the other hand, referred to the planned consumption of goods and

services of an individual for a particular period of time. Whereas transitory consumption

referred to unexpected and unplanned consumption.

Cm=Cp+Ct

According to Dr. Friedman, permanent consumption was an increasing function of permanent

income.

Cp=f ( Yp )

Or,

Cp=KYp

Which can be rewritten as,

Cp
K=
Yp

The above equation indicates that the constant K, represents the APC of the individual in the

long run. K is considered to be constant since permanent income and permanent consumption

are constant values that have already been known previously with certainty to the individual.
Dr. Friedman has tried to identify the factors that has lead to the proportionality of

consumption to income in the long run. He has identified three main factors,

1. Ratio of property and non-property income to total wealth,

2. Rate of interest,

3. Consumer’s propensity to consume.

K=f ( r , w , u )

Friedman had further investigated into permanent income. He advocated that permanent

income was a function of current income as well as previous period income.

Yp=αYt + βYt −1

Where, Yp = permanent income, α = mpc of current income, Yt = current income, β = mpc of

previous period income, Yt-1 = previous period income.

Since we know that permanent consumption is a function of permanent income, the above

equations can be rearranged as,

Cp=K . αYt + K . βYt−1

Therefore, permanent consumption according to Friedman was dependent on current and

previous period income.

In the above diagram, income is represented on the x-axis while consumption is represented on

the y-axis. The CL curve represents the long run consumption line while Cs and Cs1 represent

short run consumption lines. When the individual’s income level is at OY level, his consumption

level is EY. This comprises of both permanent and transitory income and consumption. When

his income increases from OY to OY1, consumption does not increase from EY to E1Y1; instead, it

increases from EY to E2Y1 along the Cs line. This is because the individual believes that his

increase in income is transitory. When this increase in income becomes permanent,

consumption immediately increases from E2Y1 to E1Y1, which indicates proportionality of

consumption in the long run and less than proportional increase of consumption in the short

run.

Criticisms of the Permanent Income hypothesis:

1. The Permanent Income Hypothesis assumed that transitory income and transitory

consumption were uncorrelated which was uncrealistic.

2. He assumed that transitory income and permanent income were also uncorrelated which

was proven otherwise by empirical studies.

3. He assumed that expectations were backward-looking when they were in fact forward-

looking.

4.3.5. The Life Cycle Hypothesis:

Ando and Modigliani were the economists who propounded the Life Cycle Hypothesis. The life

cycle hypothesis believes that consumption is a function of time, and savings.

This theory assumes that:

1. Rate of interest is zero

2. The individual has earned all his/her assets and has not inherited/bequeathed property

from/to anyone else

 3. The individual spends all his life earnings

4. He knows for certainty about his income inflow

5. He plans his consumption

According to this theory, an individual’s life is split into three-time frames: childhood, working

man and old age. When the individual is a child, he does not have a regular flow of income.

However, his consumption levels are not zero. This is because he dissaves to fulfil his basic

needs and necessities. When he becomes a working adult, he has a regular flow of income. His

consumption levels slightly increase. It is at this stage in his life, that he earns the most and

saves the most. When he reaches the last stage of his life, he again dissaves to maintain his

newly acquired standard of living.

This is illustrated in the below diagram.

Time is represented on the x-axis and consumption is represented on the y-axis. The CC 1

represents the consumption curve while the Y0YY1 curve represents the income line. The income

line cuts the consumption line at point B in the first time period T1, where dissaving of BCY0

takes place. When income increases slowly from Y0 to Y in the next time frame T1T2, the

individual saves BSY from his earnings. Income levels decline from Y to Y1 due to old age and

decrepitude, which again results in dissaving C1Y1S to maintain consumption.

Ando and Modigliani also gave an equation for their theory. According to them consumption

was a function of expected labour income (Yϵ ¿ , current labour income (Y ¿ and wealth (W)

C=f (Yϵ , Y , W )

Criticisms of The Life Cycle Hypothesis:

1. This theory assumes planned consumption which is unrealistic and improbable in real

life.

2. This theory neglects locked-up savings (or investments) which are usually done by

individuals in real life.

3. This theory assumes that consumption and income have a linear relationship when in

fact consumption is also affected by many other factors.