Lecture #9.

EQUILIBRIUM 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 (spent portion of Y)
S = Saving (unspent portion of Y)

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
C
450
400
350

300
250
4
200 5

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:

DC
MPC =
DY
 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:
DS
MPS =
DY

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
C
400

300

200

S
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
Employmen Income
t

Increase
Additional Consumptio
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.