ACLC COLLEGE OF TACLOBAN

Tacloban City

BUSINESS AND ACCOUNTANCY DEPARTMENT

ECONOMICS

MODULE 3: The Demand Estimation

The Consumption Function

The Savings Function

Demand Estimation

In theory, it is possible to say that aggregate supply can be met by aggregate demand.

Ehen a businessman invests or expands production, he does so because he instinctively knows that
there is a demand for his product. If he produces more than what is demanded, he would be creating a
surplus. Surplus for him is a problem. If the good in question is a perishable commodity, then he should
dispose of surplus as soon as possible before it rots. If the goods in question is not perishable like shoes,
ball pens, appliances, etc., he has to put up additional expenses for storage costs. It is possible that he
would make a profit if the prices of these commodities would rise in the future. But in the meantime, he
would reduce production because there is less demand for them.

If he produces less than what is demanded, the pressure would come from the consumers who
would be demanding more. If he could have estimated demand more correctly, then he could have sold
more and could have earned more profits

The Consumption Function

There is a close relationship of aggregate consumption expenditure to the level to the level of
disposable income. Consumption depends on many factors, but in the theory of income determination,
the consumption expenditure of the community id determined by the community’s level of disposable
income.

Propensity to consume or the consumption function is the schedule that relates consumption to
disposable income.

A consumption function for a hypothetical economy is shown below:

 Consumption Investment

y=c+s

C=I

+ C

+ .

45 degrees

200 400 yd

Aggregate Demand

Disposable income is measured on the horizontal axis, consumption is measured in a vertical axis.
The 45-degree line is a guideline which denotes that any point on the line is equidistant from the two
axis.

The slope of consumption function, or marginal propensity to consume indicates the percentage of
each additional peso or disposable income that will be consumed. The value of the marginal propensity
to consume is less than one because it is assumed that the community would only spend a percentage
of the peso and save the remainder. For our purpose, we denote the marginal propensity to consume as
b.

Another concept has to be introduced to understand consumption function. It is assumed that even
at zero disposable income, consumption takes place. Ex. Students, children, unemployed persons do not
have income yet they consume. For our purpose, we will assign small letter a, to denote the level of
consumption at zero disposable income.

Let us assume that the level of consumption at zero disposable income is P50 billion and marginal
propensity to consume is .75 (i.e. 75 percent). At what point would consumption be equal to income?
The solution is given as follows:

Consumption function is given as:

C = a + by

Given: a = 50

b = .75

c = 50 + .75y

The point where Consumption = Income (i.e. break-even point) can be represented as: C = Y
 c = a + by

if c = a + by

y = 50 + .75y

y - .75 = 50

.25y = 50

y = 50/.25

y = 200

Thus, the point where consumption just equals income is placed at P200 billion would yield dissavings, if
income is higher than P200 billion, positive savings can be realized. The graph below will show this
relationship.

How much would consumption be at other income levels? The following examples will show us how
consumption can be computed at given income levels.

y = 200

if y = 100

c=?

c=a+by

= 50 + .75 (100)

= 50 + 75

c = 125

s = -25

if y = 400

c=?

c=a+by

= 50 + .75 (400)

= 50 + 300

c = 350

s=y–c

= 400 – 350

s = 50

Schedule on Income, Consumption

 (in billion pesos)

Income (Y) Consumption (C)

100 135
200 300
300 275
400 350
500 425
600 500

The Savings Function

Figure 45 also shows the schedule of intended savings, or the “savings Function”. Savings is the
difference between consumption and income. Thus, it may be read on the diagram as the difference
between C and the 45-degree line, or it may be plotted directly as the S-function. See example below:

In our example, if income is 100 and consumption is 125, savings is -25 (S = Y – C, -25 =100 -125). The
break – even point i.e. y = c is found where y = 200 and C = 200. In this case, savings is 0, (y – c = s, 200 –
200 = 0). Any point where income is greater than consumption, for example, if y = 300, C = 275, savings
is 25 (300 – 275 = 25)

Schedule of Income, Consumption and Savings

(in million pesos)

Income (Y) Consumption (C) Savings (S)

100 125 (25)
200 200 0
300 275 25
400 350 50
500 425 75
600 500 100

Consumption savings y= C + S
550

C = C (y)

200 s=Y-C

50

50 100 200 500 550 income

-50

The Consumption and Savings Functions