Equilibrium Level of Income

Consumption is the part of income spent on goods and services yielding direct satisfaction.
It occupies the biggest chunk of the expenditure on output.

Y=C+S
Where Y = Income
C = Consumption
S = Saving

Factors influencing consumption include the following:

1. Distribution of national income. When income is equally distributed, then many will
have the opportunity to consume. Therefore, consumption will be high. However, if
income is unequally distributed (with the rich people getting the lion share of the
income) then the many poor are deprived to consume. Hence, consumption is low.

2. Interest rate. A high interest rate encourages people to save and consume less.

3. Desire to hold cash. For some personal or business reasons, some people desire to
hold cash, thereby decreasing consumption.

4. Price Level. During inflation when prices are high, people tend to spend more.

5. Population. A high population makes more people to buy goods and services.

6. Income. High income implies more consumption.

7. Taxes. More tax on income reduces disposable income thereby decreasing

consumption.

8. Attitudes and values. People’s attitudes and values over cash can influence
consumption. Those who are typically thrifty have lower consumption while those
who are extravagant naturally have higher consumption.

(Reference: Fajardo, 1990)

Consumption function is the relationship between consumption and income. All things
being equal, the amount of consumption depends on income. The higher the income, the
higher also is the consumption and vice versa.

Table 27. Consumption schedule

Income Consumption
100 185
200 240
300 300
400 365
500 420
600 470
 Consum ption
600

550
500
450

400
350

300

250

200
150
Incom e
100
100 200 300 400 500 600

Figure 41. Consumption Function

Changes in the income result to changes in the consumption. It can be measured by

taking the marginal propensity to consume (MPC) or the slope of the consumption function.
Algebraically, it is obtained with this formula:

C
MPC =
Y

If the consumption is equal to the income, then the MPC is equal to one. When the
consumption is less than the income, the MPC gets less than one. And when the
consumption exceeds income, the MPC is greater than one. Is it possible that the
consumption gets higher than the income? This is possible by utilizing past savings or
getting into borrowing.

Saving is the part of income that is not consumed. If the income equals the
consumption, there is no saving. When the income exceeds the consumption, the saving is
positive and when the income is less than the consumption, the saving is negative or there is
a dissaving.
S=Y–C

Table 28. Consumption and savings schedule

Income (Y) Consumption Savings
100 185 -85
200 240 -40
300 300 0
400 365 35
500 420 80
600 470 130
 A change in the income can affect the saving. This can be measured thru the
marginal propensity to save (MPS) or the slope of the saving function. The formula is as
follows:
S
MPS =
Y

Table 29. Marginal propensity to consume and save.

Income (Y) Consumption Savings MPC MPS
100 185 -85 - -
200 240 -40 0.55 0.45
300 300 0 0.60 0.40
400 365 35 0.65 0.35
500 420 80 0.55 0.45
600 470 130 0.50 0.50

Consum ption,
Savings
600

500

400

300

200

100

0 Income
100 200 300 400 500 600
-100

-200

Figure 42. Consumption and Savings

If the consumption function is

C = a + bY Where a = intercept
b = slope or MPC
C = 20 + 0.90 Y

a = (intercept) 20 means that if income is zero, consumption is equal to 20 units.

b = (slope or the MPC) 0.90 means that for every P1.00 additional income, P0.90
is spent for consumption expenditures.
To derive the savings function from the above given consumption function, below is the
procedure:

Since, Y = C + S
Substitute the value of C (given above) into Y = (a + bY) + S
Y = a + bY + S
Y - bY = a + S
1-b(Y) – a = S
Re-arranging:
S = -a + 1-b(Y)
Substituting the values given above:
S = -20 + (1-0.90)Y
S = -20 + 0.10 Y

a = (intercept) –20 means that if there is no income, saving is

-20. Notice that the result is consistent with the consumption function. If
there is no income, there is still consumption of 20 suggesting a
dissaving (-20).

b= (slope or MPS) 0.10 means that if there is a P1.00 additional

income, P0.10 will be saved.

Investment and the Multiplier Effect

Investment is the expenditure on new capital goods. Capital goods are the produced
goods which are used to produce other goods.

Investment is very important in an economy because it creates employment,

production and consumption. It is one important (and most fickle) component of the
country’s GNP. There are various factors affecting investment. The Marginal Efficiency of
Investment (MEI) or the Returns on Investment (ROI) is one major determinant of
investment. This is affected by factors like population, price level, technology, peace and
order, and government policies. The interest rates affect the investment, too. A high interest
rate would definitely discourage the investors and vice versa.

When the economy is at equilibrium, the investment is equal to savings. Savings

placed in banks and other financial institutions become the funds for investments.
Investment serves as an injection to the system providing more production, income and
consumption. Investment creates more income several times. This is called the multiplier
effect.

Example: Mr. Eman Wang Chu put up a noodle factory. He invested P10 M. The
P10M becomes the income of those who built the factory and those who supplied the
materials needed in the construction. But this is not the end of the flow. Those workers and
construction suppliers who initially received the P10M salary use their income to purchase
their daily needs. So another group of people would receive the same money invested by
Mr. Eman Wang Chu. And the process goes on and on. This is the multiplier effect. A
single investment has created a repercussive series of income.
(Reference: Fajardo, 1990)
 The schematic explanation of the multiplier effect is shown below:

Additional Increase Income

Employment

Increase
Additional Consumption
Investment

Additional Increase
Production Demand

Figure 43. The Multiplier Effect

The concept of multiplier is related to accelerator effect. The effect of consumption on

investment is called the accelerator effect. More consumption encourages the businessmen
to increase production which opens the way for more employment. More employment on the
other hand stimulates more income which leads again to higher consumption. This
accelerates the economic growth.

Paradox of Thrift

At equilibrium, saving equals investment. According to the classical economists, the

economic growth depends on capital formation. In order to accumulate capital, it is
necessary for society to save for investment funds. Hence, more savings is good because
more funds will be available for investment. However, according to John Maynard Keynes,
the attempt of consumers to save more will reduce savings. This is known as the paradox of
thrift (Fajardo, 1990).

To illustrate the paradox of thrift, here is an example. Suppose everyone will not buy
soft drinks as a form of savings (being thrifty), then the soft drinks industry will eventually
collapse. Everyone employed in the industry becomes jobless. They will not have any
income. Consumption of other goods and services inevitably will decrease. Production of
these goods and services will go down and massive lay-off of workers follows. This situation
perpetuates until the economy shrinks. When this happens, savings will contract. Evidently,
what is good therefore to an individual may be inimical to all.

Seatwork: Answer the following problems.

A. Given the following consumption function:

C = 40 + 0.75Y

1. Compute S if Y = 100 1. Answer: _________

2. Compute S if Y = 200 2. Answer: _________
3. Compute the break-even income 3. Answer: _________
4. Graph the consumption function and locate the break even income. Please label
your graph properly.