Consumption and Consumer

Expenditure

Chapter 12
William H.Branson
Consumption expenditure is simply assumed
to be a function of income less taxes:
c= c(y- t(y)) 0< c΄< 1

Where,
c= the real consumer expenditure
y= the real income
t(y)= tax function
The short–run consumption function that keynes
introduced is shown
c
c(y)

y
As incomes increase people tend to spend a
decreasing percentage of income, or conversely
tend to save an increasing percentage of income.
The slop of a line from the origin to a point on the
consumption function gives the average
propensity to consume (APC), or c/ y ratio.
c
c(y)

y
The slope of the consumption function is MPC ≡c ‫׳‬
It is observed that MPC<APC, Why?
If the ratio c/y falls as income rises, the ratio of the
increment to c to the increment to y, c΄, must be
smaller than c/y.
Keynes saw this as the behavior of consumer
expenditure in the short run over the duration of a
business cycle.
He reasoned that as income falls relative to recent
levels, people will protect consumption standards
by not cutting consumption proportionally to the
drop in income, and conversely as income rises,
consumption will not rise proportionally.
If the ratio c/y falls as income rises, the ratio of the
increment to c to the increment to y, c΄, must be
smaller than c/y.
Keynes saw this as the behavior of consumer
expenditure in the short run over the duration of a
business cycle.
He reasoned that as income falls relative to recent
levels, people will protect consumption standards by
not cutting consumption proportionally to the drop in
income, and conversely as income rises,
consumption will not rise proportionally. The same
kind of reasoning can also be applied in the cross-
sectional budget studies.
Acceptance of the theory that MPC<APC, so that as
income rises c/y falls, lead to the formation of
stagnation thesis around 1940. Therefore, if
consumption followed this pattern, the ratio of
consumption demand to income would decrease as
income grew. The problem for fiscal policy that the
stagnation thesis poses can be seen as follows.
If y= c + i + g
Or, 1= c/y + i/y + g/y
This is the condition for equilibrium growth of real
output, y. Unless govt. spending increases at a faster
rate than income, the economy will not grow but will
stagnant.
For instance, during the World War II, as govt.
purchase soared, the economy expand rapidly.
However, private demand increased sharply
when war ended, causing inflation rather than
recession. Why did this happen?
In 1946 Simon Kuznets published a study of
consumption and saving behavior during the
Civil War. He pointed out two important insights
about consumption behavior:

First, it appeared that on average over long run the

ratio of consumer expenditure to income, c/y or
APC, showed no downward trend, so the
marginal propensity to consume equaled the
average propensity to consume as income grew
along trend.
This meant that along trend the c= c(y) function
was a straight line passing though the origin as
shown below: Long-run function: MPC= APC
c
Short-run function:
MPC < APC

y
Fig: Long-run and short-run consumption function
Second, Kuznets’ study suggested that years when
the c/y ratio was below the long-run average
occurred during booming periods, and years with
c/y above the average occurred during periods of
economic slump. This means that the c/y varied
inversely with income during cyclical
fluctuations.
A theory of consumption must account for three
observed phenomena:
1. Cross-sectional budget studies show s/y increasing
as y rises, so that in cross-section of the population,
MPC< APC
2. Business cycle, or short-run data show that the c/y
ratio is smaller than average during boom periods
and greater than average during slumps, so that, in
the short run, as income fluctuates, MPC < APC.
3. Long-run trend data show no tendency for the c/y to
change over the long run, so that as income grows
along trend, MPC= APC.