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Consumption function

“Consumption is the sole end and


purpose of all production.” Adam
Smith
A relation between consumption and its
various determinants is called the
consumption function. The consumption
function taking all these determinants into
account can be written as:
C=f (Yd, W, Ye, P, Pe, r, s…..)
Keynes consumption function:
• Keynes, however, asserts that income alone is the
most important determinant of consumption.
• Consumption function refers to the income –
consumption relationship.
• Functional relationship between two aggregates,
i.e. total consumption and gross national income.
Symbolically, C = f (y)
Where C = consumption, Y = income and
f is the functional relationship
Propensity to consume
• It refers to the ratio between the aggregate
consumption and aggregate income or
between increased consumption and
increased income.
• It refers to the schedule that shows the
relationship between different levels of
income and different levels of consumption.
Consumption Schedule
It is the tabular representation of various amounts of
consumption expenditure corresponding to different levels
of income
Income (In Rs. Cr.) Consumption (in Rs. Cr.) Saving (in Rs. Cr.)

0 10 -10

100 100 0

200 190 10

300 280 20

400 370 30

500 460 40
Consumption function
diagram(Y1Y2>C1C2; 45 degree line
zero-saving line)
Features of Propensity to Consume

• Psychological concept: influenced by


subjective factors.
• Unequal propensity to consume: Due to low
income of the poor they are forced to spend
their entire income on consumption.
• Income and employment depends on
propensity to consume.
• Consumption in the short run.
• Long run consumption function.
Kinds or Technical Attributes of the
Propensity to Consume
• Average propensity to consume (APC)
• Marginal propensity to consume (MPC)
1. APC – The average propensity to consume is
the ratio of consumption expenditure to any
particular level of income.
APC = Consumption / Income
APC = Y / C
2. MPC – The marginal propensity to consume is
the ratio of change in consumption to a
change in income.
MPC = Change in consumption
Change in income
Characteristics of MPC
• It is always positive.
• Generally it is greater than zero and less than
unity.
• Constant MPC in the long period.
• Falling MPC in the short period.
Causes of Fall in MPC with Increase in
Income
• Fulfillment of the basic needs.
• Constant habits in the short period.
• Consumption expenditure and level of income
in the past.
• Uncertainty of future.
Significance of MPC
• Over the long run APC and MPC are equal and
approximate 0.9.
• MPC is assumed to be positive and less than
unity which means that consumption is an
increasing function of income and it increases
by less than the increase of income.
• marginal propensity to consume (MPC) is
positive but less than unity (0<MPC<1).
Propensity to save and Saving function

• It is a schedule showing relation between


income and saving at different levels of
income.
• Saving function and Propensity to save may be
defined as a schedule showing amounts that
will be saved at different levels of income.
Kinds of propensity to save
• Average propensity to save (APS) – It is the ratio
of saving to income at different levels of income.
APS = S / Y
APS = 1- APC
• Marginal propensity to save ( MPS) – it is the ratio
of change in saving to change in income.
MPS = change in saving / change in income
MPS = 1 - MPC
Keynes’s Psychological law of Consumption
• This law says “that men are disposed as a rule and on the
average to increase their consumption as their income
increases but not by as much as the increase in their
income”.
• Keynes argue that when the income increases, consumption
also increases but not to the same extent as the increase in
income.
Assumptions
• It assumes a constant Psychological and Institutional factors
which means that income distribution, tastes, habits, social
customs, price movements, population growth, etc remain
constant and consumption depends on income.
• It assumes the existence of normal conditions. The law does
not operate in abnormal conditions like war, revolution or
hyperinflation.
• It assumes the existence of lasseiz-Fare Capitalist economies
and is in operative in case of socialist economies.
Three related Propositions
1. When Income increases, consumption
expenditure also increases but by a smaller
amount. Thus, it increases less than
proportionately.
2. The increased income will be divided in some
proportion between consumption expenditure
and saving.
3. Increase in income always leads to increase in
both consumption and saving.
Income( Y) Consumption( Savings (S)
C)
0 50 -50
50 75 -25
100 100 0
150 125 25
200 150 50
250 175 75
300 200 100
350 225 125
Determinants of Propensity to Consume

1. Subjective factors
2. Objective factors

1. Subjective factors – relates to the


psychological characteristics of human nature
and social practices. These factors are further
divided into 2 categories:
Individual factors Business factors
1. foresightedness 1. Extension of business.
2. Economic independence. 2. Liquidity preferences.
3. Enlarged income in future. 3. Financial prudence.
4. Occupational motive. 4. Modernization and income raise.
5. Bequeathing a fortune.
6. Miserliness.
7. Status in the society.
8. Precautionary and speculative motive.
2. Objective factors:
1. Changes in the wage level.
2. Windfall gains or losses.
3. Changes in the fiscal policy.
4. Changes in expectations.
5. Change in the rate of interest.
6. Financial policies of corporations.
7. Holding of liquid assets.
8. Distribution of income.
9. Attitude towards savings.
10. Duesenberry hypothesis.
11. Expectation of future income.
12. Change in population.
13. Attraction of new products.
14. Credit and installment facilities.
Measures to raise the Propensity to Consume

• Income Redistribution
• Increased Wages
• Social Security Measures
• Credit Facilities
• Advertisement
• Development of the Means of Transport
• Urbanisation
QUESTION QUESTION
Calculating APC and MPC
Yd C APC ?? MPC ?? S ??

0 100 - - -
100 175
200 250
300 325
400 400
500 475
600 550
Calculating APC and MPC
Yd C APC MPC S=Yd-C

0 100 - - -100
100 175 1.75 0.75 -75
200 250 1.25 0.75 -50
300 325 1.08 0.75 -25
400 400 1 0.75 0
500 475 0.95 0.75 25
600 550 0.92 0.75 50
QUESTION

• Suppose, initial income level is


Rs. 1000 and consumption
demand is Rs. 800. When income
level increases to Rs. 1500, and
consumption demand to Rs.
1200, MPC will be:
Marginal Propensity to Consume
• Suppose, initial income level is Rs. 1000 and consumption
demand is Rs. 800. When income level increases to Rs. 1500,
and consumption demand to Rs. 1200, MPC will be:
• =∆C/ ∆Yd =400/500=0.80
• This implies that when income increases by Rs. 100,
consumption demand increases by Rs 80. And the difference
Rs. 20 is the saving.
• This means Yd = C+S
• i.e. Disposable income=Consumption+Saving
Question
Income Consumption MPC MPS
300 300 - -
400 375 - -
500 445 - -
600 510 - -