THEORY OF CONSUMPTION

By consumption we mean the satisfaction of our wants by the use of

commodities and services.

The consumption function or propensity to consume refers to income-

consumption relationship. It is a “functional relationship between two
aggregates, i.e., total consumption and gross national income.” Symbolically,
the relationship is represented as C = f(Y), where C is consumption, Y is
income, and f is the functional relationship. Thus the consumption function
indicates a functional relationship between C and Y, where C is the dependent
by Y is the independent variable, i.e., C is determined by Y. This relationship is
based on the ceteris paribus (other things being equal) assumption, as such
only income-consumption relationship is considered and all possible
influences on consumption are held constant. In fact, the propensity to
consume or consumption function is a schedule of the various amounts of
consumption expenditure corresponding to different levels of income.

The Average propensity to Consume:

“The average propensity to consume may be defined as the ratio of
consumption expenditure to any particular level of income.” It is found by
dividing consumption expenditure by income, or APC = C/Y. It is expressed as
the proportion of income consumed.

(2) The Marginal Propensity to Consume:

“The marginal propensity to consume may be defined as the ratio of the
change in consumption to the change in income. It can be found by dividing
change in consumption by a change in income, or MPC = ∆C/∆Y.
Diagrammatically, the three propositions are explained in Figure. Here,
income is measured horizontally and consumption and saving are measured
on the vertical axis. C is the consumption function curve and 45 o line
represents income.
APC
1. APC = ----

2. APC=70/60 =1.166

3. APC= 120/120 = 1

4. APC= 170/180 = 0.94

5. APC= 220/240 = 0.916

6. APC= 270/300 = 0.9

MPC
1. MPC = 70-60 / 60-0 = 10/60 = 0.166
2. MPC = 120-70 / 120-60 =50/60 = 0.833
3. MPC =0.8
4. MPC = 0.8
The life cycle hypothesis accounts for the dependence of consumption and
saving behaviour on the individual’s position in the life cycle. Young workers
entering the labour force have relatively low incomes and low (possibly
negative) saving rates. As income rises in middle-age years, so does the saving
rate. Retirement brings a fall in income and might be expected to begin a
period of dissaving (negative saving rates).

Motivation for life-cycle consumption patterns

 Diminishing marginal utility of income. If income is high during working life, there is a
diminishing marginal utility of spending extra money at that particular time.
 Harder to work and earn money, in old age. Life Cycle enables people to work hard
and spend less.
Criticisms of Life Cycle Theory

 It assumes people run down wealth in old age, but often this doesn’t happen as
people would like to pass on inherited wealth to children. Also, there can be an
attachment to wealth and an unwillingness to run it down.

 It assumes people are rational and forward planning. Behavioural economics

suggests many people have motivations to avoid planning.

 People may lack the self-control to reduce spending now and save more for future.

 Life-cycle is easier for people on high incomes. They are more likely to have financial
knowledge, also they have the ‘luxury’ of being able to save. People on low-incomes,
with high credit card debts, may feel there is no disposable income to save.

 Leisure. Rather than smoothing out consumption, individuals may prefer to smooth
out leisure – working fewer hours during working age, and continuing to work part-
time in retirement.

 Government means-tested benefits for old-age people may provide an incentive not
to save because lower savings will lead to more social security payments.
Q1. Calculate the Consumption (C), Average Propensity to Consume and
Marginal Propensity to Consume (MPC) for the given data of an Economy.

Level of Output and Income(GDP=DI) in Savings in Million Consumptio APC = C/Y MP

Million Dollars (Y) Dollars n in Million C
Dollars
240 -4 244 244/240=1.0 0.8
1
260 0 260 260/260=1 0.8
280 4 276 276/280= 0.8
0.98
300 8 292 292/300= 0.8
0.97
320 12 308 308/320= 0.8
0.96
340 16 324 324/340=0.9 0.8
5
360 20 340 340/360= 0.8
0.94
380 24 356 356/380=
0.93

260-244/260-240

16/20=0.8

276-260/280-260=16/20=0.8

APC=1

Y=C+S

S= Y-C

C=Y-S

APC=C/y
MPC=Change in C/ Change in Y

Q2. Calculate Average Propensity to Consume and Marginal Propensity to

Consume (MPC) for the given data of an Economy.

MPC= 1040-950/ 1100-1000

90/100= 0.9

1120-1040/1200-1100= 0.8

= 0.7
= 0.6
= 0.5
APC= 950/1000=0.95

1040/1100= 0.945

= 0.933
= 0.915
= 0.892
=0.866