CONSUMPTION FUNCTION

Consumption function or propensity to consume refers to the general income consumption relationship. It represents functional relationship between two aggregates i.e., total consumption and total income. It shows how consumption expenditure varies with given changes in income.

ACCORDING TO K. KURIHARA

“Consumption represents amount of consumer expenditure made at a given level of income, whereas the propensity to consume is a schedule of consumer expenditure at various income levels.”

ACCORDING TO A.H. HANSEN

“The consumption function shows what changes can be expected in the consumption from given change in income.”

ACCORDING TO DERNBURG AND MCDUGALL.

“The schedule that relates consumption to disposable income is called the propensity to consumption function.”

ACCORDING TO R.G. LIPSY

“Consumption function is nothing more than a statement of the relation between consumption expenditure and income.”

Thus, consumption function simply represents the functional relationship between income and consumption. Symbolically, it is expressed as C = f(Y) i.e. consumption (C) is a function (f) of income (Y).

FEATURES OF CONSUMPTION FUNCTION

The main features of consumption function or the propensity of consume are summarised below:

(i) Consumption function shows functional relation between income and consumption. It is a psychological concept. It is influenced by subjective factors, like consumer’s preferences, habits etc.

(ii) The basis of consumption function is provided by the psychological law of consumption which states the human tendency that as income increases, the consumption also increases, but by a smaller amount.

(iii) Propensity to consume of the poor classes (with low incomes) is higher than that of the rich classes (with high incomes).

(iv) There is a direct relationship between propensity to consume and employment. Employment increases with the increase in propensity to consume and falls with the fall in propensity to consume.

(v) Consumption function is stable in the short period, i.e., there are no shifts in the consumption curve in the short period.

(vi) Consumption function no longer remains Stable and shifts occur in the consumption curve in the long period because the subjective factors on which consumption function depends may change in the long period.

(vii) At zero income level, consumption expenditure is autonomous and is independent of income. But, as income increases, consumption increases according to the psychological law of consumption.

TECHNICAL ATTRIBUTES OF CONSUMPTION FUNCTION

The consumption function has two technical attributes (or properties):

AVERAGE PROPENSITY TO CONSUME (APC)

Average propensity to consume (APC) is defined as the ratio of absolute consumption to absolute income. It is found by dividing consumption expenditure by income, or APC = C/Y. It tells us the level of consumption at a given level of income.

For example, if at income level Rs. 200 crores, the consumption expenditure is Rs. 180 crores, then APC = C/Y = 180/200 = .9 or 90%.

The APC declines as income increases because the proportion of income spent on consumption decreases. Diagrammatically, the average propensity to consume represents any one point on the consumption curve.

In Figure above, point A on consumption curve CC measures the average propensity to consume at income level OY1. APC at point A = OC1/OY1. The CC curve flattens to the right which shows declining APC.

MARGINAL PROPENSITY TO CONSUME (MPC)

Marginal propensity to consume (MPC) refers to the ratio of small change in consumption to small change in income. It is found by dividing change in consumption by change in income, or MPC = ∆C/∆Y. For example, if income increases from Rs. 200 to 250 crores, and the consumption increases from Rs.180 to 220 crores, then MPC = ∆C/∆Y = 40/50 = .80 or 80%.

Column 4 in Table shows constant MPC (80%) at all levels of income. Diagrammatically, the marginal propensity to consume is measured by the slope or gradient of the consumption curve.

In Figure, the marginal propensity to consume between point A and B is measured as MPC = ∆C/∆Y = C1C2/Y1Y2 or BD/AD.

Properties of MPC

The concept of marginal propensity to consume has the following properties or characteristics:

1. MPC is Greater than Zero but Less than One:

This property is the technical expression of the psychological law of consumption. The value of MPC is always greater than zero because consumption expenditure must increase with the increase in income. MPC is less than one because the whole of increase in income is not consumed; a part of it is saved.

Thus, Keynes’ psychological law of consumption can be technically stated as:

O < MPC < 1 or O < ∆C/∆Y < 1

i.e., MPC is positive but less than unity.

2. MPC Falls with Successive Increase in Income:

This is due to the fact that as a community becomes richer, it has the tendency to consume smaller percentage of each increment to its income. It is because of this property that the consumption curve flattens out when it moves from left to right.

3. MPC of the Poor is Greater than that of the Rich:

This is because of the fact that the poor people spend a greater percentage of their income on consumption, while the rich people spend a smaller proportion. The rich already enjoy a high standard of living and therefore tend to save most of the increments of their income. On the other hand, most of the basic needs of the poor remain unsatisfied.

Therefore they tend to spend larger amounts of their income on consumption. This is the reason why in backward countries, like India. Pakistan, Sri Lanka, Indonesia, etc., MPC is higher, while in advanced countries, like U.K., U.S.A., Germany, Japan, etc., MPC is lower.

4. The Short-Run MPC is Stable:

It is because the psychological and institutional factors on which the propensity to consume depends do not change in the short period.

RELATION BETWEEN APC AND MPC

APC and MPC are closely related to each other in the following way:

(i) APC refers to the ratio of consumption to income at a particular point of time. MPC represents the ratio of change in consumption to change in income. MPC is the rate of change in APC.

(ii) In the case of a linear consumption function (straight line consumption curve) with positive consumption expenditure at zero income level,

(a) APC is falling, while MPC is constant, and

(b) APC is always higher than MPC.

This is clear from Figure below. The slope of consumption curve CC (which represents MPC) is constant at all levels of income.

APC, which is represented by the slope of the line from origin O to any point on CC curve, declines as income increases. As income increases from OY1 to OY2, APC falls from C1 Y1/OY1 to C2Y2/OY2 (or the slope of C2O is less than the slope of C1O). APC is always higher than MPC; it is also evident because the slopes of C1O and C2O are greater than the slope of CC.

(iii) When a linear consumption function passes through the origin, APC is equal to MPC and both are constant. In Figure-3B, the slope of consumption curve OC (indicating MPC) and the slope of the line from origin O to any point on consumption curve (indicating APC) are the same (i.e., C1Y/ OY1 = C1 Y1/OY1).

(iv) In case of curvilinear consumption function, (a) as income increases, the APC as well as MPC both decline, but the decline in MPC is more than the decline in APC; and (b) as income falls, both APC and MPC rise, but APC rises at a slower rate than MPC.

(v) Keynes was more concerned with MPC because his analysis was related to the short period, while APC is useful in the long period. In the short period, there is no change in MPC and MPC << APC. In the long period, according to the post-Keynesians, APC and MPC are equal and are about .9.

FACTORS AFFECTING CONSUMPTION FUNCTION

According to Keynes, two types of factors influence the consumption function: subjective and objective. The subjective factors are endogenous or internal to the economic system itself. The subjective factors relate to psychological characteristics of human nature, social structure, social institutions and social practices.

These are likely to remain more or less stable during the short period. Established behaviour pattern undergoes material change only over long periods. These factors fundamentally determine the form of the consumption function (i.e., slope and position of the propensity to consume, the С curve).

The objective factors affecting the consumption function are exogenous, or external to the economy itself. These factors may at times undergo rapid changes. Thus, objective factors may cause a shift in the consumption function.

SUBJECTIVE FACTORS

The subjective factors affecting consumption function include psychological characteristics of human desires or wants. Consumption and saving behavior of individuals with regards to increased income is dependent on their psychological motives.

Social practices and modern social order relating to the behavior of business firms concerning wage and payment of dividend and retained earnings are also responsible determining the consumption function.

Keynes has highlighted some motives on such human nature:

a. Precaution Motives

Individuals would want to prepare themselves to any unseen emergencies like sickness, unemployment, accidents, etc. So they keep reserves for such situations.

b. The Motive of Foresight

Foresight motives include human needs related to future such as old age support, educational needs for children, etc.

c. Standard of Living

Individuals would want to improve their standard of living. For this, they would increase their level of savings for future undertakings.

d. The Motive of Independence

The motive to be independent is a drive towards consumption function as it leads to more saving and less consumption at present.

e. The Motive of Enterprise

Individuals may have a desire to start their own business enterprise. So, they cut down their present consumption expenses and make more savings.

OBJECTIVE FACTORS

Income Distribution:

Keynes believed that the MPC of low income groups would be higher than that of high income groups. So, aggregate demand could be stepped up by a policy of income redistribution — i.e., transferring income from the rich to the poor.

Changes in the distribution of income may alter consumption demand if high-income households consume a smaller proportion of disposable income than do low-income households. If national income were redistrib­uted toward low-income households having a larger propensity to consume, the aggregate consumption schedule would rise, while a less equal redistribu­tion of income would have the opposite effect for similar reasons.

The impact of income redistribution on consumption expenditures is not unam­biguous, however. If higher-income groups spend a large portion of their income to “keep up with the Joneses,” income redistribution in favour of low- income households will have an uncertain impact on the consumption schedule.

The Rate of Interest:

It has long been supposed that an increase in the rate of interest would lead to an increase in savings and, therefore, a reduction in consumption.

Other things remaining the same, the lower the real interest rate, the greater is the amount of consumption expenditure and the smaller is the amount of saving. The real interest rate is the opportunity cost of consump­tion.

This opportunity cost arises regardless of whether a person is a borrower or a lender. For a borrower, increasing consumption this year means paying more interest next year. For a lender, increasing consumption this year means receiving less interest next year.

The effect of the real interest rate on consumption expenditure is an example of the principle of substitution. If the opportunity cost of an action increases, people substitute other actions in its place. In this case, if the opportunity cost of current consumption and substitute future consump­tion in its place.

Liquid Assets and Wealth:

Both the supply of liquid assets (money, securities, or bonds) and the wealth represented by existing quantities of durable goods may influence consumer expenditures.

Consider liquid assets first. Many observers contend that a greater stock of liquid assets enhances feelings of economic security and may thereby prompt greater consumption expenditures.

Expected future income:

The higher a household’s expected future income, other things remaining the same the greater is its consumption expenditure. That is, if two households have the same disposable income on consumption goods and services.

Sales effort:

An increase or decrease in the amount of sales effort may affect the total volume of consumer expenditures, given the level of income. Advertising has the effect of shifting demand from one product to another. But, as Ackley has put it, whether as a result of advertising, aggregate consumption, expenditure will fall or not is debatable. It is the matter of empirical (statistical) test and verification.

Capital Gains:

Keynes also recognised that consumption spending might be influenced not only by income but by capital gains.

Consumer Credit:

The terms of consumer credit have often been important in influencing consumption behaviour in respect of durable goods like automobiles, TV sets, radios, etc.

The extent to which consumers can borrow to finance purchases may affect their levels of consumption. The demand for durable goods like appliances and automobiles is particularly sensitive to the availability of credit, because such goods involve sizable expenditures.

A high level of debt may dampen consumer demand, because repayment in the future will be necessary, making less funds available for current consumption. In addition, interest rate levels, the maximum time period for repayment, down-payment requirements, and the ease of access to financial institu­tions may cause consumer spending for durable goods to increase or decrease.

Fiscal Policy:

Tax and transfer payments also affect consumption. An increase in indirect taxes raise commodity prices and may lead to a fall in the demand for the taxed commodity. Likewise an increase in income tax may reduce the disposable income of individuals and may lower total consumption expenditure.

Other Factors:

These include certain motives to consumption such as enjoyment, short-sightedness, generosity, miscalculation, ostentation and extravagance. Keynes calls these subjective factors.

DIFFERENCE BETWEEN APC AND MPC

BASIS OF DIFFERENCEAPCMPC
MEANINGAverage propensity to Consume refers to the ratio of Consumption Expenditure to the corresponding level of income.Marginal propensity to consume refers to the ratio of change in Consumption Expenditure (△C) to change in total income (△Y).
FORMULAAPC = Consumption (C)/Income (Y)MPC = Change in Consumption (△C)/Change in Income (△Y)
VALUEIt can be greater than 1, equal to 1 or less than 1.Its value lies between 0 and 1.
CAN BE ZEROIt can never be zero.Its value can be zero.
EXAMPLESupposing at a given level of income of 300 crore consumption is 250 crore then APC will be 250/300 which is equal to 0.83.Suppose income increases by 100 crore and consumption increases by 50 crore then MPC = 50/100 which is equal to 0.5.

MEASURES TO RAISE PROPENSITY TO CONSUME

Marginal Propensity to Consume (MPC) is the extra amount that people consume when they receive an extra amount of disposable income (Income after paying tax) .The short run production function is stable as it is very difficult to change in the short period of psychological and institutional factors affecting the propensity to consume of the people. However in long ,raising propensity to consume is possible by the following measures:

1)Income Redistribution:

Income Redistribution helps to increase MPC. Government should redistribute national income in favor of the poor people by imposing progressive taxes on the rich and providing subsidies to the poor people. When income redistribution takes place poor people also become able to consume goods and services.

2)Wage Policy:

Wage Policy helps to increase MPC. In long run transfer of income from non wage group through progressive taxation, subsidies is affected  with the help of new wage policy. This type of wage policy will increase the consumption expenditure of wage earners.

3)Social Security:

Social Security  helps to increase MPC. Some of the social security measures like unemployment compensation , old age pension ,health ,insurance etc. helps to raise and stabilize consumption function. According to Kurihara ,a social security program is regarded as a solution to the “paradox of thrift(people try to save money during an economic recession ,which leads to fall in economic growth)” common to all wealthy capitalist economies.

4)Credit Facilities:

Producers should provide easy and cheap credit facilities for the purchase of consumer durables like motorbike,T.V,refrigerators ,etc  which will lead to increase the marginal propensity to consume of the people.

5)Urbanization and Colonization:

Urbanization and Colonization also helps in increasing MPC. The propensity to consume of the people living in cities and newly developed colonies is higher than that of the village people.

6)Advertisement and publicity:

Advertisement and publicity helps in increasing MPC. The proper program of publicity through advertisement helps in bringing notice to the consumers about the product and services.

7)Interpersonal Comparison:

Interpersonal Comparison helps to increase MPC. Interpersonal Comparison of the living standards of the people living in different regions of the same country as those of living in different countries create new requirements and thus increase expenditure in the new consumption item.

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