Consumption Function

What is GDP?
Gross Domestic Product (GDP)- is the nations expenditure on all the final goods and services produced during the year at market price. One way to calculate GDP is by adding all of Nations expenditures.

Nations Expenditures
Consumption Investment
Government Spending Net Exports

C + I + G + NX= GDP
This lecture will concentrate on Consumption

Consumption
Consumption is the nations expenditures on all final goods and services produced during the year at market prices. The total of everyones expenditures is called consumption. Consumption is designated by the letter C.

Consumption
C is the largest sector of GDP C is just over two-thirds of GDP The consumption functions states : As income rises, consumption (C) rises, but not as quickly Therefore, consumption varies with disposable income (DI)

Aggregate Consumption
Is the sum total of all expenditure on current consumption goods and services which are consumed currently eg. Food, clothing, fuel, rent etc. At low levels of income, almost entire income is spent on current consumption. As income level increases, some income is kept aside for saving.

 The relation between aggregate consumption expenditure and aggregate income of household sector is known as Consumption Function. C = f (Y)

Gross Domestic Saving

Income not spent on current consumption is saved. In an economy, some consumers may spend less than their income and some may spend more than their income. Gross Domestic saving is the difference between GDP and Aggregate Consumption.

Saving Function
The relation between aggregate saving (S) and income (Y) is called as Saving Function. Saving function is given as : Y = C + S.

Consumption and Disposable Income

As Income rises so does Consumption BUT NOT AS QUICKLY!
DI increases . . . C increases but by a smaller amount DI decreases . . . C decreases but by a smaller amount

Two Ways To View ConsumptionIncome Relationship 1. As the ratio of total consumption to total disposable income. 2. As the relationship of changes in consumption to changes in disposable income.

Average Vs. Marginal

The average propensity to consume (APC) is total consumption in a given period divided by total disposable income.

Average Propensity to Consume

Consumption APC = ----------------------------------Disposable Income

Disposable Income Rs.40,000

Consumption Saving Rs.30,000

Disposable Income Rs.40,000

Consumption Saving Rs.30,000 Rs.10,000

APC = ------------ = ------------ = ------ = .75

DI 40000 4

30000

Disposable Income Rs.40,000

Consumption Saving Rs.30,000 Rs.10,000

APC = ------------ = ------------ = ------ = .75

DI 40000 4

30000

S 10000 1 APS = ------------ = ------------ = ------ = .25 DI 40000 4

Disposable Income Rs.40,000

Consumption Saving Rs.30,000 Rs.10,000

APC = ------------ = ------------ = ------ = .75

DI 40000 4

30000

+
S 10000 1 APS = ------------ = ------------ = ------ = .25 DI 40000 4

1.00

Disposable Income Rs.20,000

Saving Rs.1,500

Disposable Income Rs.20,000

Saving

Consumption Rs.18,500

Rs.1,500

Disposable Income Rs.20,000

Saving

Consumption Rs.18,500

Rs.1,500

APC = ------------ = ------------ = ------ = .925

DI 20000 40

18500

37

Disposable Income Rs.20,000

Saving

Consumption Rs.18,500

Rs.1,500

APC = ------------ = ------------ = ------ = .925

DI 20000 40

18500

37

S 1500 3 APS = ------------ = ------------ = ------ = .075 DI 20000 40

Disposable Income Rs.20,000

Saving

Consumption Rs.18,500

Rs.1,500

APC = ------------ = ------------ = ------ = .925

DI 20000 40

18500

37

+
S 1500 3 APS = ------------ = ------------ = ------ = .075 DI 20000 40

1.00

APCs Greater than One

Disposable Income Rs.10,000 Consumption Rs.12,000 Saving

APCs Greater than One

Disposable Income Rs.10,000 Consumption Rs.12,000 Saving - 2000

Where is this going to come from?

APCs Greater than One

Disposable Income Rs.10,000 Consumption Rs.12,000 Saving - 2000

APC = ------------ = ------------ = ------ = 1.2

DI Rs.10,000 10

Rs.12,000

12

APCs Greater than One

Disposable Income Rs.10,000 Consumption Rs.12,000 Saving - 2000

APC = ------------ = ------------ = ------ = 1.2

DI Rs.10,000 10 S -Rs.2,000 -2 APS = ------------ = ------------ = ------ = -0.2 DI Rs.10,000 10

Rs.12,000

12

APCs Greater than One

Disposable Income Rs.10,000 Consumption Rs.12,000 Saving - 2000

APC = ------------ = ------------ = ------ = 1.2

Rs.12,000

12

DI

Rs.10,000

10

S -Rs.2,000 -2 APS = ------------ = ------------ = ------ = -0.2 DI Rs.10,000 10

1.00

The Marginal Propensity to Consume

The marginal propensity to consume (MPC) is the fraction of each additional (marginal) rupee of disposable income spent on consumption.

Marginal Propensity to Consume (MPC)

MPC =

CHANGE CHANGE

in Consumption in Income

Marginal Propensity to Consume (MPC)

Year 1998

DI Rs.30000

C Rs.23000

S Rs.7000

1999

Rs.40000

Rs.31000

Rs.9000

Marginal Propensity to Consume (MPC)

Year 1998 Change 1999

DI Rs.30000 10000 Rs.40000

C Rs.23000 8000 Rs.31000

S Rs.7000 2000 Rs.9000

Year 1998 Change 1999

DI Rs.30000 10000 Rs.40000

Change in C

C Rs.23000 8000 Rs.31000

8000 8 10000 10

S Rs.7000 2000 Rs.9000

MPC =---------------- = ---------- = ------- = .8

Change in DI

Year 1998 Change 1999

DI Rs.30000 10000 Rs.40000

Change in C

C Rs.23000 8000 Rs.31000

8000 8 10000 10

S Rs.7000 2000 Rs.9000

MPC =---------------- = ---------- = ------- = .8

Change in DI

Change in S 2000 2 MPS = -------------- = ---------- = -------- = .2 Change in DI 10000 10

1.0

Graphing Consumption Function

Rs.6000?

Consumption & Saving

Rs.1000

45 Rs.1000 Rs.6000

Disposable Income

Graphing the Consumption Function

Expenditure (Rs.)

3 0 ,0 0

2 0 ,0 0

1 0 ,0 0

4 5 1 0 ,0 0

If Consumption rose at the same rate as Disposable Income . . . A graph of this function would be a 45 line

Disposableble incom ($) Income (Rs.) D o isp sa e

2 0 ,0 0

3 0 ,0 0

Saving = Rs.300

Rs.6000 5700 Rs.3000 Rs.2700

Dissaving-= Rs.300 Saving = Rs.300 Rs.2700 Rs.6000

Disposable Income

Saving

Dissaving

Disposable Income

Graphing the Consumption Function

Expenditure (Rs.)
DI
3,000

3000 1750
C

2,000

1,000

45 1,000 2,000 3,000 Disposable income ($)

Disposable Income (Rs.)

Consumption is the vertical distance between the bottom (horizontal) axis and the C line.

Graphing the Consumption Function

Expenditure (Rs.)
DI
3,000

3000 1750 1250

C

2,000

1,000

45 1,000 2,000 3,000 Disposable Income Disposable income ($) (Rs.)

Saving is the vertical distance between the C line and the 45 degree line

Graphing the Consumption Function

DI
3,000

3000 1750 1250 2000 1440

C

2,000

1,000

45 1,000 2,000 3,000 Disposable income ($)

Consumption is the vertical distance between the bottom (horizontal) axis and the C line.

Graphing the Consumption Function

Expenditure (Rs.)
DI
3,000

3000 1750 1250 2000 1440 560

C

2,000

1,000

45 1,000 2,000 3,000 Disposable income ($)

Saving is the vertical distance between the C line and the 45 degree line

Graphing the Consumption Function

DI
3,000

2,000

3000 1750 1250 2000 1440 560 1000 1000

1,000

45 1,000 2,000 3,000 Disposable income ($)

Consumption is the vertical distance between the bottom (horizontal) axis and the C line.

Graphing the Consumption Function

DI
3,000

2,000

3000 1750 1250 2000 1440 560 1000 1000 0

1,000

45 1,000 2,000 3,000 Disposable income ($)

Saving is 0 at 1000 DI because there is NO distance between the C line and the 45 degree line.

Graphing the Consumption Function

DI
3,000

2,000

3000 1750 1250 2000 1440 560 1000 1000 0 0 625

1,000

45 1,000 2,000 3,000 Disposable income ($)

Consumption is the vertical distance between the bottom (horizontal) axis and the C line.

Graphing the Consumption Function

DI
3,000

2,000

3000 1750 1250 2000 1440 560 1000 1000 0 0 625

1,000

45 1,000 2,000 3,000 Disposable income ($)

When DI is 0 the level of Consumption is called Autonomous Consumption (AC)

Graphing the Consumption Function

DI
3,000

2,000

3000 1750 1250 2000 1440 560 1000 1000 0 0 625 -625

1,000

45 1,000 2,000 3,000 Disposable income ($)

Saving is the vertical distance between the C line and the 45 degree line. Saving is negative to the left of where the C line crosses the 45 degree line

Autonomous Consumption versus Induced Consumption

Autonomous means Self Governing Autonomous consumption (AC) is the level of consumption when disposable income is 0 It is called autonomous because it is independent of change in disposable income

Induced Consumption
Induced consumption (IC) is that part of consumption which varies with the level of disposable income As disposable income rises, induced consumption rises As disposable income fall, induced consumption falls

C = Autonomous C + Induced C
So Induced C = C Autonomous C IC = C - AC

This is your Autonomous Consumption

Rs.0

Disposable Income

Graphing the Consumption Function

DI
3,000

2,000

3000 1750 1250 2000 1440 560 1000 1000 0 0 625 -625 IC = C - AC

1,000

45

IC = 625 - 625
1,000 2,000 3,000 Disposable income ($)

DI = 0 What is IC?

IC = 0

Graphing the Consumption Function

DI
3,000

2,000

3000 1750 1250 2000 1440 560 1000 1000 0 0 625 -625 IC = C - AC

1,000

45

IC = 1000 - 625
1,000 2,000 3,000 Disposable income ($)

DI = 1000 What is IC?

IC = 375

Graphing the Consumption Function

DI
3,000

2,000

3000 1750 1250 2000 1440 560 1000 1000 0 0 625 -625 IC = C - AC

1,000

45

IC = 1440 - 625
1,000 2,000 3,000 Disposable income ($)

DI = 2000 What is IC?

IC = 815

Graphing the Consumption Function

DI
3,000

2,000

3000 1750 1250 2000 1440 560 1000 1000 0 0 625 -625 IC = C - AC

1,000

45

IC = 1750 - 625
1,000 2,000 3,000 Disposable income ($)

DI = 3000 What is IC?

IC = 1125

Consumption & Saving Function

Consumption

Consumption Function Y=C+S C = a + bY Where a = autonomous & b = MPC When Y = 0, C = a So, 0 = a + S i.e S = -a

a 0
Saving

45 o y

When Y = Y, C = Y, S = 0 So, Y = Y + S i.e. S = 0 Disposable Income

Saving

-a

Saving Function Y=C+S Y = (a + bY) + S Y (a + bY) = S Y a bY = S -a + Y bY = S -a + Y( 1 - b) = S (1-b) = MPS

Determinants of Consumption
1. Disposable Income The most important determinant of consumption 1. Credit Availability 2. Stock of Liquid Assets in the hands of consumers 3. Stock of Durable Goods 4. Keeping up with the neighbors.. 5. Consumer Expectations

The Determinants of Saving

There is no single reason why people save Some spend virtually all of their disposable income Some spend more than they earn Americans now save less than 5% of disposable income