Consumption Function

& Investment Function

The Concept of Consumption Function
 As the demand for a good depends upon its price, similarly
consumption of a community depends upon the level of
income. In other words, consumption is a function of
income. The consumption function relates the amount of
consumption to the level of income. When the income of a
community rises, consumption also rises.
 The consumption function is the whole schedule which
describes the amounts of consumption at various levels of
income.
Linear Consumption Function
 Consumption function should be carefully distinguished from
the amount of consumption. By consumption function is
meant the whole schedule which shows consumption at
various levels of income, whereas amount of consumption
means the amount consumed at a specific level of income.
The schedule described above reflects the consumption
function of a community i.e., it indicates how the
consumption changes in response to the change in income.
 The above schedule of consumption function reveals an
important fact that when income rises, consumption also rises
but not as much as the income. This fact about consumption
function was emphasized by Keynes, who first of all evolved the
concept of consumption function. The reason why consumption
rises less than income is that a part of the increment in income is
saved.
 Consumption demand depends on income and propensity to
consume. Propensity to consume depends on various factors such
as price level, interest rate, stock of wealth and several
subjective factors. Since Keynes was concerned with short run
consumption function he assumed price level, interest rate,
stock of wealth etc. constant in his theory of consumption. Thus
with these factors being assumed constant in the short run,
Keynesian consumption function considers consumption as a
function of income. Thus
 C= f(Y)
 Keynesian consumption function has been depicted by CC’ curve in
Fig. 6.1 in which along the X-axis national income is measured and
along the Y-axis the amount of consumption is measured. In this
figure, a line OZ making 45° angle with the X-axis, has been
drawn. Because line OZ makes 45° angle with the X-axis every
point on it is equidistant from both the X-axis and Y-axis.
 Therefore, if consumption function curve coincides with 45° line
OZ it would imply that the amount of consumption is equal to the
income at every level of income. In this case, with the increase in
income, consumption would also increase by the same amount.
 As has been said above, in actual practice consumption increases
less than the increase in income. Therefore, in actual practice the
curve depicting the consumption function will deviate from the
45° line. If we represent the above consumption schedule by a
curve, we would get the propensity to consume curve such as CC
in Fig. 6.1.
 It is evident from this figure that the consumption function curve CC’
deviates from the 45° line OZ. At lower levels of income, the
consumption function curve CC lies above the OZ line, signifying that
at these lower levels of income consumption is greater than the
income.
 It is so because at lower levels of income, a nation may draw upon its
accumulated savings to maintain its consumption standard or it may
borrow from others. As income increases, consumption also increases
and at the income level OY0, consumption is equal to income.
 Beyond this, with the increase in income, consumption increases but
less than the increase in income and therefore, consumption function
curve CC lies below the 45° line OZ beyond Y 0. An important point to
be noted here is that beyond the level of income OY 0, the gap
between consumption and income is widening. The difference between
consumption and income represents savings. Therefore, with the
increase in income, saving gap also widens and as we shall see later,
this has a significant implication in macroeconomics.
 It is useful to point out here that when the consumption
function of a community changes, the whole consumption
function curve changes or shifts. When propensity to consume
increases, it means that at various levels of income more is
consumed than before.
 Therefore, as a result of increase in propensity to consume of
the community, the whole consumption function curve shifts
upward as has been shown by the upper curve C’C’ in Fig. 6.2.
On the contrary, when the propensity to consume of the
community decreases, the whole consumption function curve
shifts downward signifying that at various levels of income, less
is consumed than before.
Keynes's Psychological Law of Consumption
 The normal Physiological Law holds that when the real income
of the community increases or decreases , its consumption will
increase or decrease, but no so fast.
 In other words, as income increases, consumption also
increases but not in the same proportion as increase in income,
and vice versa.
 This is because, as one adds to one’s consumption with
expansion of one’s income, he comes closer to the point of
saturation beyond which consumption is less likely to be
stretched.
 It means, the proportion of income saved increases as income
increases.
 Keynes’ Law of consumption is related to three different
propositions:
1. When the income of the community increases, its consumption
expenditure also increases but by somewhat smaller amount.
While proportion of income saved increases with the increase in
the level of income.

2. It means the increased income will be divided into to

proportion as saving and spending.

3. It is unlikely that an increase in income will lead to either less

spending or less saving than before, rising income is often
accompanied by increased saving and falling income by
decreased saving.
 Assumption of the Keynes’ Psychological Law of
Consumption:

1. It is assumed that in short run, habits, tastes, customs, price

level, size of population, pattern of Income distribution, etc.
do not change and that consumption expenditure depends on
income only.
2. The conditions are normal and the economy is not facing
any abnormal or extraordinary circumstances such as war,
floods or famines, inflation, etc.
3. The existence of a wealthy capitalist economy based on
laissez faire policy, that is, it is a free economy in which
there are no government restrictions on consumption and
saving.
 Implication of the Law:
1. This law invalidates the Say’s Law of Market as Income
increases, expenditure also increases but not in the same
proportion, but it increases in less proportion as compared
to income. Therefore, it is not correct to say that supply
creates its own demand.
2. The law underlines the importance of investment in any
programme of full employment. As the gap between income
and expenditure arises there, which is being bridged by
increase in investment or else it will lead to depression and
unemployment.
3. It also gives importance to state intervention. As
consumption increases in less proportion to income, there
arises a situation of over- production and general
unemployment. Here, the need for appropriate monetary
and fiscal policy arises.
4. The law also explains the turning point of business cycle. The
downward turning point from the boom is explained by the fact
that although people’s income increases, the consumption
expenditure does not increases in the same proportion, likewise
the upper turning point from a depression is explained by the
fact that although people’s income decreases the consumption
expenditure cannot be reduced in same proportion: a minimum
level of consumption has to be incurred.
Propensity to consume
 In dealing with the consumption function or the propensity to
consume, Keynes considered its two technical attributes: (1)
Average propensity to consume and (2) marginal propensity to
consume.
1. Average propensity to consume: The average propensity
to consume is defined as the ratio of aggregate or total
consumption to aggregate income in a given period of time.
APC=C/Y
It follows that the average propensity to save will be the ratio
of aggregate or total savings to aggregate income in a given
period of time.
APC=S/Y
 The economic significance of the APC is that it tells us what
proportion of total cost of a given output from planned
employment can be expected to be recovered by selling
consumer goods alone.
 It tells us what proportion of total amount of goods and
services demanded by the community originates in the demand
for consumer goods.
 The average propensity to save tells what proportion of total
cost of a given output will have to be recovered by the sale of
capital goods.
 Other things remain equal, the relative development of
consumer goods and capital goods industries in an economy
depends on APC and APS.
2. Marginal Propensity to Consume:

 The Marginal propensity to consume is the ratio of the

change in the level of aggregate consumption to a change in
level of aggregate income. It refers to the effect of additional
income on consumption.
 MPC can be found by dividing a change in consumption by
a change in income;
MPC= ΔC/ΔY.
Where (delta) indicates the change
C denotes consumption
Y denotes income.
 Here we have taken linear consumption function and that is the
reason why the above schedule shows 0.8 or 80% MPC for each
level of income.
 The MPC is always positive but less than one. This is because of
the psychological law of consumption as it purports that the
increase in consumption will be less as compared to increase in
income.
 Here, as people are also keen to save their part of income and
therefore we can say that,
MPC= ΔC/ΔY < 1
 Another significance about the concept is marginal propensity
to save, which can be found by using following equation:
MPC= 1- MPC
 Factors affecting the Consumption function:
A. Subjective Factors: The factors which may change the slope and
position of the consumption function.
1. The motive of precaution.
2. The motive of foresight; anticipated future needs.
3. The motive of calculation; large real consumption is preferred at later
date than to a smaller immediate consumption. (desire to earn interest.)
4. The motive of Improvement; Gradual increase in standard of living is
desired.
5. The Motive of independence; desire to enjoy the power to do things
independently.
6. The motive of Enterprise; desire to secure and establish business
projects.
7. The motive of Pride; desire to possess a fortune.
8. The motive of liquidity; desire to face emergencies and difficulties
successfully.
B. Objective Factors: factors that are capable of rapidly changing
the shape and amount of consumption function.
1. Windfall gains or losses: Due to windfall gains to people, the
consumption can change suddenly. Sudden loss can reduce the
level of consumption unexpectedly.
2. Fiscal policy: the changes made by the government in fiscal
policy can change the pattern of consumption. Imposition of
heavy taxes reduces the disposable income of the people and
leads to reduction in the level of consumption and vice-versa.
3. Change in Expectation: The expectations regarding future
changes also affects the consumption of the community.
Expected war may increase the consumption because of the
probable future scarcity.
4. The rate of interest: Significant rise in rate of interest may
induce people to reduce their consumption at each income
level, because people will save more in order to make
advantage of the high interest rates.
5. Changes in wage rate: As the workers are having higher propensity to
consume, increased wage rate will also increase the level of
consumption. The consumption curve shift up with the increase in wage
rate.
6. Financial policies of the corporation: If the joint stock companies are
retaining higher amount profit for expansion purpose and giving very
less amount of dividend to the shareholders, the consumption curve
shifts downward.
7. Pattern of income distribution: MPC is different for the each section of
the society. Generally the poor has higher propensity to consume than
the rich. Hence if the income is transferred from the rich to poor, total
consumption in the economy will increase and consumption curve will
shift up.
8. Amount of wealth: People who possess higher amount of wealth are
less worried about the future uncertainties of life. They save less and
consume more out of their current income. Conversely people who
possess no wealth will save more and consume less out of the current
income.
 Significance of the concept of Consumption function:

1. The concept of consumption function disproves Say’s law of

market that supply creates its own demand.
2. Due to stability of the concept in the short run, it underlines
the importance of investment in the theory of income and
employment.
3. The concept provides satisfactory explanation to the up-turns
and down-turns in business cycle.
4. It also helps in explaining the over saving phenomenon and
declining trend of marginal efficiency of capital in rich
countries.
5. It is also helpful in understanding the concept of multiplier.
Investment Function
 In ordinary parlance, investment means to buy shares, stocks, bonds and
securities which already exist in stock market. But this is not real
investment because it is simply a transfer of existing assets. Hence this is
called financial investment which does not affect aggregate spending. In
Keynesian terminology, investment refers to real investment which adds
to capital equipment.
 It leads to increase in the levels of income and production by increasing
the production and purchase of capital goods. Investment thus includes
new plant and equipment, construction of public works like dams, roads,
buildings, etc., net foreign investment, inventories and stocks and shares
of new companies. In the words of Joan Robinson, “By investment is
meant an addition to capital, such as occurs when a new house is built or
a new factory is built. Investment means making an addition to the stock
of goods in existence.”
 Capital, on the other hand, refers to real assets like factories, plants,
equipment, and inventories of finished and semi-finished goods. It is any
previously produced input that can be used in the production process to
produce other goods. The amount of capital available in an economy is
the stock of capital. Thus capital is a stock concept.
 To be more precise, investment is the production or acquisition of real
capital assets during any period of time. To illustrate, suppose the capital
assets of a firm on 31 March 2004 are Rs 100 crores and it invests at the
rate of Rs 10 crores during the year 2004-05. At the end of the next year
(31 March 2005), its total capital will be Rs 110 crores. Symbolically, let I
be investment and К be capital in year t, then It = Kt– Kt- 1.
 Capital and investment are related to each other through net investment.
Gross investment is the total amount spent on new capital assets in a
year. But some capital stock wears out every year and is used up for
depreciation and obsolescence. Net investment is gross investment minus
depreciation and obsolescence charges for replacement investment. This
is the net addition to the existing capital stock of the economy.
 If gross investment equals depreciation, net investment is zero and there
is no addition to the economy’s capital stock. If gross investment is less
than depreciation, there is disinvestment in the economy and the capital
stock decreases. Thus for an increase in the real capital stock of the
economy, gross investment must exceed depreciation, i.e., there should
be net investment.
 As Keynes has pointed out here the importance of investment function as
the gap between the income and consumption must be bridged by
investment.
 Investment function is viewed in the context of marginal efficiency of
capital and the rate of interest. Changes in any of these variable brings
about changes in the volume of investment. Thus during a given period,
investment is a function of marginal efficiency of capital and tare of
interest .
 I = F (e, r)
I= Investment, F= function
e= Marginal efficiency of capital and r= Rate of interest
 Determinants of Investment:
1. Marginal Efficiency of Capital:
 Keynes first introduced the concept of marginal efficiency of capital in the year
1936 and according to him it is a key determinant of investment.
 In general marginal efficiency of capital means expected rate of profit, or the
expected rate of return over cost or the expected profitability of the capital
asset.
 MEC means “the rate of discount which would make the present value of the
annual returns expected from the capital asset during its life just equal to its
supply price.”
 According to Kurihara, “MEC is the ratio between the prospective yield of
additional capital assets and their supply price. Symbolically:
e = OP
Where, e = MEC
O = expected yield of a capital asset per unit of
time P = Supply price of the asset.
i. Prospective yield from capital asset: It refers to the amount of
annual income which an investor expects to get by selling the output
of his investment or capital asset, after deducting the running
expenses of obtaining that output during its life time. It is the
aggregate return from an asset during its life time.
ii. Supply price of the asset: It is a price which an investor has to pay to
acquire the capital asset. It is a cost of producing it.

The marginal efficiency of capital can be calculated as follows:
 2 n
SP =R1/ (1+i) + R2 (1+i) + Rn/(1+i)

Where Sp is the supply price or the cost of the capital asset, R 1 R2…
and Rn are the prospective yields or the series of expected annual
returns from the capital asset in the years, 1, 2… and n, i is the rate
of discount which makes the capital asset exactly equal to the
present value of the expected yield from it.
 This i is the MEC or the rate of discount which equates the two sides
of the equation. If the supply price of a new capital asset is Rs 1,000
and its life is two years, it is expected to yield Rs 550 in the first year
and Rs 605 in the second year. Its MEC is 10 per cent which equates
the supply price to the expected yields of this capital asset.
 Thus
2
 (Sp) Rs 1000 = 550/(1.10) + (605)/(1.10) = Rs. 500 + 500
 In equation (1), the term R1/(1+i) is the present value (PV) of the
capital asset. The present value is “the value of payments to be
received in the future.” It depends on the rate of interest at which it
is discounted.
 Marginal Efficiency of Capital and Volume of Investment:
 Along with the supply price and expected yield of the asset, MEC
also depend upon Volume of Investment. Normally the MEC of an
asset tends to progressively diminish as investment in that asset
increases.
 This is because of the following reasons:
1. Due to more amount of investment, the asset will be produced
more and due to which the expected yield will tend to decline as
they will compete against each other to meet consumers demand
and in this process , their general earnings will decline.
2. The supply price of the asset will also increase as more production
of the asset will lead to decline in the available resources for the
production of asset.
This can be illustrated with the help of schedule and a curve.
Diminishing marginal efficiency of Capital

Investment (Rs. in MEC (in %)

crores)
1000 12
2000 10
4000 8
6000 6
8000 4
10000 2
 Diminishing marginal efficiency of Capital
14
MEC (IN %)/ RATE OF INTEREST

12
12

10
10

8
8

6
6

4
4

2
2

0
0 2000 4000 6000 8000 10000 12000

INVESTMENT (RS. IN CRORES)

Marginal efficiency of Capital and Rate of Interest
 Investment depend on the MEC and the rate of interest. MEC is again
result of the supply price and the prospective yield of capital asset.
 The rate of interest on the other hand, is determined by the demand for
and supply of money. On demand side, the rate of interest is determined
by the liquidity preference of the people and on supply side by supply of
money available in the economy.
 We can directly compare the MEC and rate of interest as both are ratios.
 Such comparison is essential because investment in a capital asset
depend on a rational comparison between the supply price of an asset
and its demand price.
 The supply price of an asset is the sum of prospective yields discounted
by MEC, while its demand price is the sum of expected future yields
discounted at the current rate of interest.
 By comparing the supply price and demand price, the following
observations may be made as regards investment decisions:

1. When the marginal efficiency of capital is greater than the rate of

interest, that is to say demand price is higher than the supply price ,
the investor will continue to make fresh investments.
2. When the MEC is equal to the rate of interest, i.e. supply price is
equal to demand price, the effect on investment will be neutral.
3. When the MEC is less than the rate of interest, i.e. when the demand
price is less than the supply price, the investors will stop making new
investments.
 TTTs TTT TT TTTTTTTTT wTtT tTT TTTT TT sTTTTuTT TTT T TurvTT
Supply price Annual return MEC Rate of Effect on
(`) (`) interest investment
25000 1000 4% 4% Neutral
20000 1000 5% 4% Favourable
25000 1000 4% 5% Unfavourable
 Factors affecting Marginal Efficiency of Capital:
1. Business expectations and Business Confidence: Optimistic business
expectations leads to higher marginal efficiency of capital and
pessimistic business environment leads to lower MEC.
2. Stock of Capital goods: Existence of large stock of capital goods will
lead to lower MEC because due to large capital stock Marginal
productivity of capital will be low and along with that, due to large
capital stock, production of finished goods will be large. The market
price of the finished goods will tend to decline, so the prospective
yield of the capital asset will be low.
3. Technological Progress: inventions and innovations tend to increase the
MEC.
4. Development of New Areas: the opening up of New Markets increases
the MEC.
5. New Product: As the sale of new product are high and expected
revenues are more than the cost, the MEC will be high.
7. Population Growth: Increase in population leads to increase in
demand of all kinds of consumer goods and investment goods. MEC
will also increase along with the increase in demand and vice-versa.
8. Government policy: in case of imposition of heavy taxes on companies
and corporations, MEC will tend to decline. Even indirect taxes will
increase the prices of the finished goods and demand will come down.
This will reduce the MEC. If state provides infrastructural facilities
like transport, communication, power, etc. credit facilities and other
subsidies will increase MEC.
9. Political Climate: Political instability, adversely affects the MEC.
Stable government and peaceful political relations leads to higher
MEC.
Thank You