Theory of Consumption Function Notes

CONTENTS
Objectives
Introduction
7.1 Keynes Consumption Function Theory
7.2 Absolute Income Hypothesis
7.3 Summary
7.4 Keywords
7.5 Review Questions
7.6 Further Readings

Objectives
After studying this unit, students will be able to:
 Know the consumption function principle of Keynes.
 Study absolute income hypothesis.

Introduction
In the previous unit we have described the relation between income and consumption rendered
by Keynes, which he called as consumption function. After Keynes, economists are studying some
components of consumption function and created new principles related to that. These are—
(1) Absolute income principle of Tobin; (2) Relative income principle of Dussenberry ; (3) Certain
income principle of Friedman; (4) life-cycle principle of Modigliani. Before describing these
principles we briefly explain the principle of Keynes on which all these principles are based.

7.1 Keynes Consumption Function Theory

Keynes renders the consumption function principle in his book General Theory. According to him, all
consumptions are the function of all current disposable income. It is given by-

C = a + cyd
Where a is a positive autonomous consumption that is affected by non-income component on
consumption. So it is not affected by the increment or decrement in income. It is constant. c is the
frontier consumption nature (MPC) and y d is disposable income which is left with customers as
expenses after paying tax.
The relation between consumption and income is dependent on Keynes’ ‘Psychological rule of
consumption’ which indicates that when income increases then consumption expense also increases
but in low quantity. In other words, when there is increment in income, consumption expenses are not
increased but not proportionally. The meaning of perception of this non-proportional consumption
function is that short period average nature (APC) and frontier consumption nature (MPC) are not
similar. But APC > MPC and MPC is positive but less than unity: 0 < MPC < 1. Lastly, consumption
function of Keynes takes constant
Notes value in both short period and long period. The principle of Keynes proved unsatisfied because it cannot
describe statically short period rationally in consumption and income.
For understanding that we differentiate in rational and non-rational consumption function.
Consumption function is rational when APC is constant at every level of income and equals to MPC
as shown in Fig. 7.1. Where consumption C cut on origin O. When income changes from OY 1 to OY2
then on E1 and E2 points with C curve APC = MPC. In other words, on 45° curve at point E 1 APC =
OC1/OY1 = 1 and MPC = ∆C/∆Y consumption function becomes non-proportional when with
increase in income, APC decreases. In Fig. 7.2, C is the consumption function. OY1 is income level to
the C curve at point E of APC > MPC, where APC = OC 1/OY1 and MPC = ∆C/∆Y = ER/RE0 but on
OY0 level when C intersect 45° curve at point E0, there APC = MPC.

Figure. 7.1 Figure. 7.2

Notes Keynes renders the principle of consumption function in his book General
Theory.
At the end of 1930s and at the mid of 1940s many studies were performed which were based on
time series and cross-section. By these studies Keynes principle is proved that is called absolute
income hypothesis.
In 1946 Kuznets studied the data of income and consumption of USA during the period 1869–1938
and studied consumption function of that duration 0.9. He then concluded that in the long run
average APC graph has no tendency to go downwards and so, with the increase in income APC
= MPC. Its meaning is that in long period, consumption function is a simple line that passes
on original point, as shown in Fig. 7.3 by C1 line.
Bold smith again inspected that conclusion in 1955
A.D. and concluded that long period consumption
function constant on 0.87 or 0.9. From these two
studies it is clear that consumption function
is non-rational because APC > MPC and long
period consumption function is rational, MPC =
APC. So both studies are disclaimer to each other
and become a puzzle for economists. To save
this, from many years economists have tried to
reconcile short-term consumption and long term
consumption “The solutions they have given in
them redefinition of consumption function has
Figure. 7.3
been mentioned. ”. Above we are studying such a
principle of consumption function.
 Notes

Did You Know? All customers are the function of whole disposable income.

Self Assessment
Fill in the blanks:
1. Keynes renders the principle of consumption function in his book ………………………. .
2. Being increment and decrement in income...................................expenses are also increased
and decreased.
3. The consumption function of Keynes gives the name of.....................income hypothesis.

7.2 Absolute Income Hypothesis

The consumption function of Keynes has been given the name absolute income hypothesis that
indicates when income increases, then consumption also increases but it increases less in
comparison to the increment of income and vice versa. Its meaning is that the relation of
consumption and income is non- rational. James Tobin and Arthur Smith inspected this hypothesis
in different studies and concluded that the short period relation of consumption and income is non-
rational, but by Time Series data the long period relation of both are rational. The relation of
consumption-income is because by shifting up the short-period non-rational consumption function.
For that different reasons are responsible. These reasons are described below.

Self Assessment
Multiple Choice Questions:
2. Short-duration consumption function is
(a) non-rational (b) rational
(c) a study (d) none of these
3. Long duration consumption function is
(a) rational (b) non-rational
(c) proportionate. (d) none of these.
4. When income increases during resilience period, then it increases with the increment in
saving
(a) consumption (b) non-enjoyment
(c) expenses (d) none of these
First, Prof. Tobin involved the asset holdings of Negro and White families in budget study for the
inspection of this hypothesis. He concluded that if the assets of family increase, then the
consumption also increases then accordingly the consumption function is shifted above. Second,
many new domestic consumer products came fast in use after the end of the Second World War.
Being the use of these necessary things, the consumption function was shifted to up. Third, the
nature of urbanization increased after period of the War. The transfer speeds of public from rural
areas to urban areas, the consumption function shifted up because the nature of consumption of
urban labours is more than
 Unit-7: Theory of Consumption Function

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 Unit-7: Theory of Consumption Function

Notes workers of field. Fourth, after long duration,

the population of old age people increases.
Though old age people are not earning, but
they consume things. Due to their increase in
number the consumption function is shifted
up.
According to absolute income principle, these
reasons have shifted consumption function
level side as necessary to establish rational
between consumption and income in long
period and so it stops to seem like that those
seem the non- rational relation only based on Figure. 7.4
income.

Task Express your views on consumption function principle of Keynes.

Absolute income hypothesis is presented in Fig. 7.4 where CL is a long period consumption, as we
grow with long period curve then it presents the rational relation between consumption and
income.
Example, On A and B point of that curve APC and MPC is equal. C S1 and CS2 are the short period
functions. But those reasons are described above, because of that these consumption function
increased up side from A to B point with C L. But CS1 and CS2 will not increase the dotted part of
consumption function in the same proportion as increase in income. So this part shows the non-
rational relation.
Its Critical Appraisal: The quality of that principles is that it forces all elements except income that
preset the customer-behaviour. This is not described by Keynes. But the problems are that its non-
rational consumption function continues with assumption. As Prof. Shapiro objected, “Now
economists feel that basic consumption functions are rational which means to ignore the main
principle of absolute hypothesis.”

Self Assessment
State whether the following statements are True or False:
5. This principle of Keynes proved unsatisfied because it can rationally describe the statistics
in long period in consumption and income.
6. Kuznets studied the data in 1946 of income and consumption of USA in 1869–1938 time
periods.
7. When income increases then consumption also increases.
8. Consumption function tries to re-define the free component.

7.3 Summary
 The relation between consumption and income is dependent on Keynes ‘Psychological rule
of consumption’. It indicates that when income increases then consumption expenses also
increases but in low quantity. In other words, being incremented in income, consumption
expenses are not increased proportionally.

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7.4 Keywords Notes
 Time Series: Moment chain.
 Cross-Section: Sample slice.

7.5 Review Questions

1. What do you understand by the consumption function principle of Keynes?
2. What is the meaning of absolute income hypothesis?
3. Critically evaluate the absolute income hypothesis.

Answers: Self Assessment

1. General Theory 2. consumption 3. absolute 4. (a)
5. (a) 6. (a) 7. False 8. True
9. True 10. True.

7.6 Further Readings

Books 1. Macroeconomics: Theory and Policy— H. L. Ahuja, S. Chand Publishers, 2010.