SEBI Gr A 2020

Economics
Phase
1&2
Consumption Function
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 Introduction
The level of Income and employment are dependent on Aggregate demand.

Greater the Aggregate Demand = Greater the level of Income and Employment

Why not aggregate supply?

• Because Keynes was concerned about the short run and in short run, supply
is held to be constant.

Aggregate demand depends on two factors:

1. Consumption Demand
Propensity to Consume
2. Investment Demand
Disposable Income
What is Consumption Function?

• The consumption function refers to income consumption relationship.

• It is a “functional relationship between two aggregates → Total consumption and
Gross national income.”

• Symbolically, the relationship is represented as

C = f (Y)
where С is consumption and Y is income

Note: If there is a change in any other variable affecting consumption spending there will
be a shift of the consumption function.

There are 2 components of Consumption Function:

• Autonomous Consumption
• Induced Consumption
What is Autonomous consumption?
• It is defined as the consumption that consumers must make even when they have
no disposable income.
• When times are hard, paying for these necessities can force consumers to borrow
or tap into savings.
• It is denoted by C0.

What is Induced consumption?

• It is defined as consumption depends on income and varies with income changes.
• In Keynes’ theory of income determination, variations in consumption are
explained by changes in national income.

Aggregate consumption function

• Every individual or household has its own consumption function. By adding up
the consumption functions of all households we arrive at the aggregate
consumption function.
• It shows how the total desired consumption spending of all households varies
with national income.
So, if we rewrite our consumption function-
C = C0 + [(Propensity to consume) * (Disposable Income)]

Why Propensity to Consume?

• Because people do not spend all their income on goods and services.
• So their consumption depends upon their propensity to consume.

Why Disposable Income?

• All the income generated in economy does not reaches to the household level.
• Some of it gets reduced to give taxes.
• That is why consumption of the households will depend on their Disposable Income.
Disposable Income = Income (Y) – Taxes (T)
Example:

Suppose, C0 = 500
Propensity to consume = 0.6
Disposable Income = 2000

C = 500 + 0.6 * 2000 = 1700

Autonomous Marginal Disposable Consumption
Consumption Propensity to Income 3000
consume

Consumption
2500
500 0.6 0 500
2000
500 0.6 1000 1100
C = a+ bY
500 0.6 2000 1700 1500 b
500 0.6 3000 2300 1000
500 0.6 4000 2900 500
a
Graph of Consumption function is Upward sloping, 1000 2000 3000 4000
implying that as income increases consumption Income
spending also increases.
This makes it clear that consumption changes are • Keynesian linear consumption
induced by income changes. can be written as C = a + bY
Where,
a is intercept term = C0
If consumption function curve coincides with the 45 b stands for slope = marginal
line, it would imply that the amount of consumption propensity to consume
is equal to the income at every level of income. Y = Level of current income
 Shift in Consumption Function
• When the consumption of a
community changes, the whole
consumption curve changes or
shifts.
• When propensity to consume
increases, it means that at any
given level of income, more is
consumed than before.
• Therefore, as a result of increase
in propensity to consume, the
whole consumption function
curve shifts upwards.
• On the contrary, when the
propensity to consume of the
community decreases, the whole
consumption function curve
shifts downwards.
 Propensity to Consume
There are two important concepts of
propensity to consume-
• Average Propensity to consume
• Marginal propensity to consume

Average Propensity to consume

• It is the ratio of the amount of consumption
to total income.
• Therefore, it is calculated as –
APC = C/Y

Where C = Amount of consumption

Y = Level of income

• Average propensity declines with

increase in income, because there is
inverse relationship between APC and
Income (Y).
 Propensity to Consume

Marginal Propensity to consume

• It is the ratio of change in consumption to
the change in income.
• Therefore, it is calculated as
MPC = ∆C / ∆Y

Where, ∆C = Change in Consumption

∆Y = Change in Income

• Marginal Propensity to Income

declines, when Income rises.
• Also, it is important to not that-
MPC < APC

• Marginal Propensity to consume varies between 0 and 1.

If zero → whole increment in income is saved.
If 1→ whole increment in income is consumed.
 Determinants of Propensity to Consume

Keynes divided the factors determining the propensity to consume into two groups:
1. Objective Factors
2. Subjective Factors

Objective Factors
✓ Changes in General Price Level: Real Balance Effect
✓ Fiscal Policy
✓ Rate of Interest
✓ Stock of Wealth
✓ Monetary Policy and Credit conditions
✓ Income Distribution
✓ Windfall gains and losses
✓ Change in Expectations
 Determinants of Propensity to Consume

Subjective Factors
• Subjective factors include those factors which induce and prompt people to save some part of
their income.
Like
✓ Unforeseen Contingencies
✓ Expected Future Needs
✓ To increase their Future income
✓ Wealth Creation
✓ Speculative Purposes & Other business Projects
✓ Leaving a good fortune for their heir

• The above factors increases the propensity to save and therefore reduce the propensity to
consume.

• However, Keynes pointed out that some subjective factors also increase the propensity to
consume.
• Like – Demonstration effect – People have a natural instinct to imitate others consumption
habits. People in lower and middle income ranges imitate the consumption standards of higher
income groups which increases their propensity to consume.
 Non-Linear Consumption Function
• Previously, we saw that marginal propensity to consume remains constant, that’s
why consumption function curve was a straight line.
• But according to some economists, it is not necessary that marginal
propensity to consume should be the same at all levels of income.

Autonomous Marginal Disposable Consumpti

Consumptio Propensity to Income on
n consume

500 0.9 0 500

500 0.8 1000 1300

500 0.7 2000 1900

500 0.6 3000 2300

500 0.5 4000 2500
 Saving Function
• Disposable income is either consumed or saved. Saving is defines as that part which is
not consumed.

Thus, Y = C + S
Or, S=Y–C

• Like consumption, saving is also a function of income. Thus it can be written as-
S = f (Y)
• By substituting the Keynesian consumption function for C in the equation, we get
S = Y – (a +bY)
= Y – a – bY
= -a + Y – bY
= -a + (1 - b) Y

• Note that, (1-b) is the marginal propensity to save, where b is the value of marginal
propensity to save.

Marginal propensity to save (MPS) = 1 – Marginal Propensity to consume (MPC)

MPS + MPC = 1
 Propensity to save

Average Propensity to save

• It is the proportion of disposable income
that is saved.
• Therefore, it is calculated by
APS = Savings / Disposable Income = S / Y

Like MPC,
APS + APC = 1
Or APS = 1 - APC

Marginal Propensity to save

• It is defined as the change in savings
induced by a change in disposable
income.
• It represents how much of the additional
disposable income is devoted to saving.
Thus,
MPS = ∆S / ∆Y
 Important Keynes’s Theory of Consumption

Absolute level of current Income is the important factor that determines consumption
• Classical economists thought that it was rate of interest that primarily determines saving and
consumption in the economy. While, Keynes said that Increase in National Income causes an
increase in consumption.

Marginal Propensity to Consume is less than one but greater than zero ( 0 < MPC < 1)
• This is also known as Keynes’s psychological law of consumption.
• According to this, as income increases → consumption increases, but not as much as the increase
in income.

As income increases, average propensity to consume falls

• Keynes was of the view that rich people relatively save a higher proportion of their income. That’s
why at higher level of income, average propensity to consume falls.

Consumption function remains stable in short run

• Acc. To Keynes, consumption function depends on various factors such as distribution of income
and wealth and psychological factors.
• Since, these factors does not change in short run, consumption function remain stable and does
not shift upward or downward.
Happy Learning!