Consumption Function.pdf

Ashwani Panesar, Lovely Professional University Unit 5: Consumption Function Unit 5: Consumption Function Notes CONTENTS Objectives Introduction 5.1 Concept o...

Ashwani Panesar, Lovely Professional University Unit 5: Consumption Function Unit 5: Consumption Function Notes CONTENTS Objectives Introduction 5.1 Concept of Consumption Function 5.2 Propensity to Consume 5.2.1 Absolute Income Hypothesis 5.2.2 Relative Income Hypothesis 5.3 Factors Determining Propensity to Consume 5.4 Summary 5.5 Keywords 5.6 Review Questions 5.7 Further Readings Objectives After studying this unit, you will be able to: Realise the concept of consumption function; State the assumptions of Keynes' Psychological Law; Explain the concept of Propensity to Consume; Identify the factors that affect propensity to consume. Introduction Consumption function refers to the functional or causal relationships between consumption on the one hand and the various factors determining it on the other. Your income is considered to be the chief determinant of your consumption, so the consumption function conventionally refers to the functional relationship between income and consumption. Did u know? The relationship between income and consumption has always been a subject of intense study ever since Ernst Ergel, a German statistician, formulated the "laws of consumption expenditure in 1857". On the basis of statistical data pertaining to the consumption expenditures of the sample of German households, Angel formulated a set of three generalisations which are popularly known as "Engel's laws of consumption". Engel's laws may be stated as follows: As the level of income increases, households tend to spend: a decreasing percentage of income on food, an increasing proportion of income on things such as education, medical facilities, recreation, etc. LOVELY PROFESSIONAL UNIVERSITY 87 Macro Economics Notes roughly a constant proportion of income on essential consumption items such as rent, fuel, clothing and lighting. These generalisations broadly hold from the basis of the law of consumption or propensity to consume subsequently formulated by J M Keynes. Keynes was the first to stress the importance of the relationship between income and consumption and to make it one of the central parts of Macro Economics. 5.1 Concept of Consumption Function The consumption function – the relationship between consumption and income – is largely a Keynesian contribution. Keynes postulated that consumption depends mainly on income. In regard to the relationship, he argued that consumption increases as income increases but by an amount less than the increase in income. It is, however, assumed that by income Keynes meant the "disposable income of the consumer". Keynes designated tendency of consumption varying directly with disposable income as the Fundamental Psychological Law. According to this law, "men are disposed, as a rule and on the average, to increase their consumption as their income increases but not by as much as the increase in their income. This law is known as propensity to consume or consumption function". This law consists of three propositions: 1. When aggregate income increases, consumption expenditure also increases but by a somewhat smaller amount. The reason is that as income increases, more and more of our wants get satisfied and therefore lesser and lesser amounts are spent out of subsequent increases in income. 2. When income increases, the increment of income will be divided in a certain proportion between consumption and saving. This follows from the first proposition that what is not spent is saved. 3. As income increases both consumption spending and saving will go up. Assumptions of the Law It is assumed that habits of people regarding spending do not change or propensity to consume remains the same. Normally, the propensity to consume is more or less stable and does remain unchanged. This assumption implies that only income changes whereas other factors like income distribution, price movement, growth of population, etc. remain more or less constant. The conditions are normal in the economic system. The existence of a capitalistic laissez faire economy. The law may not hold good in an economy where state interferes with consumption or productive enterprise. Explanation of the Law The most important determinant of consumption is income. In technical language consumption is a function of (determined by) income. This relationship between consumption and income is termed as "consumption function" or " the propensity to consume". C = f (Y) Where, C is consumption f is function Y is income 88 LOVELY PROFESSIONAL UNIVERSITY  Unit 5: Consumption Function Self Assessment Notes Multiple Choice Questions: 1. The consumption function shows the relationship between consumption and......................... (a) Savings (b) Income (c) Demand (d) Supply 2. Which of the following is not one of the propositions of the Psychological Law? (a) When aggregate income increases, consumption expenditure also increases but by a somewhat smaller amount. (b) When income increases, the increment of income will be divided in a certain proportion between consumption and saving. (c) As income increases both consumption spending and saving will go up. (d) When income is consistent, consumption must be equal to savings. 3. Which of the following is not a requisite for Psychological law? (a) Habits of people regarding spending do not change. (b) The conditions are normal in the economic system. (c) Existence of a capitalistic laissez faire economy. (d) State should have some degree of interference in productive enterprise. 4. Which of the following represents the consumption function? (a) C= f(Y) (b) Y=f(C) (c) C= f(1/Y) (d) C= f(C/Y) 5.2 Propensity to Consume Keynes has made use of four concepts in analysing consumption-income relationship. These are: Average propensity to consume Marginal propensity to consume Average propensity to save Marginal propensity to save Consider the following data of a hypothetical economy. Columns 1 and 2 in Table 5.1 indicate the amount of consumption expenditures of this society at various income levels. In this schedule, just as demand curve shows the purchases that will be made at different prices. Column 3 shows the savings of the society at various income levels. LOVELY PROFESSIONAL UNIVERSITY 89 Macro Economics Notes This example shows that this society begins to make positive savings only when it reaches an income of 250. Table 5.1: Data of a Hypothetical Economy Y (Income) C S (Savings) APC MPC APS MPS (Consumption) 0 60 -60 - - - - 100 150 -50 1.5 0.90 -0.5 0.10 200 220 -20 1.1 0.70 -0.1 0.30 250 250 0 1 0.60 0 0.40 350 300 50 0.89 0.50 0.11 0.50 450 345 105 0.77 0.45 0.23 0.55 The above numerical example has been presented diagrammatically in Figure 5.1 where the horizontal axis measures income and the vertical axis measures consumption expenditures. The consumption function indicating the consumption expenditures at various income levels is shown by the line cc. Draw a 45º line through the origin. Every point on this line is equidistant from the two axes. The difference between the 45º line and consumption function measures planned saving at each income level of 25º, consumption exceeds income resulting in negative savings. Beyond that income there are positive savings. Figure 5.2 draws the saving-function as corresponding to the consumption function cc in figure 5.3. Figure 5.1 Figure 5.2: Consumption and Saving Functions 90 LOVELY PROFESSIONAL UNIVERSITY  Unit 5: Consumption Function Figure 5.3 Notes As the level of income increases, households generally increase consumption expenditure but less than proportionally. On the contrary, when the level of income decreases, households are constrained to reduce consumption, but by a smaller amount. The reason for this 'tendency' or 'propensity' is not far to seek. The satisfaction of the immediate basic needs of households is usually a stronger motive than the motive toward accumulation. Hence, at lower income levels, households are constrained to spend almost the entire income and sometimes spend more than the income on the consumption needs. ! Caution As a result, saving, which is the difference between income and consumption, tends to be either "zero" or even "negative". Negative saving is also called dissaving, which means that at low incomes households may have to use up their past savings or borrow in order to keep their consumption expenditure in excess of their income. But as the income level rises, since most of the basic consumption needs are satisfied, the households do not find it essential to increase the consumption expenditure in the same proportion. As a result, savings tend to rise more than proportionately when income rises. Since saving is the difference between income and consumption and since consumption depends on income it follows that saving also depends on income. This relationship between saving and income is called the "propensity to save" or the "saving function". The nature of relationship between the disposable household income on the one hand and the household consumption and saving on the other can be explained with the help of a simple linear equation (as stated earlier): Y is C+S...(1) Where Y is disposable income C is consumption S is saving This equation says that a household, disposable income is partly consumed and partly saved. The income-consumption relationship can be specified by the equation: C = a + b.Y (a>0, 0