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Consumption FunctionConsumption function or propensity to consume is first and important component of effective demand.

Effective Demand: effective demand represents the actual expenditure on consumption and investment at any equilibrium level of employment.This shows the total demand for goods and services in the economy.

The concept of consumption function is illustrated by Keynes with the heading, Keynes Psychological Law of Consumption.The concept of consumption function in general theory is based on the psychological tendency with regard to consumption.

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According to Keynes, the volume of consumption depends upon the size of income.

There is a stable functional relationship between total income and consumption, this relationship is called Propensity to Consume or Consumption function, and Shown as:

C = f(Y)It shows there is a functional relationship between the

total consumption and total income. Thus, the propensity to consume refers to the actual

expenditure on consumption at various levels of income.

It demonstrates that when income increases, consumption also increases but not to the same extent as the increase in income.

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According to Keynes: “The psychology of the community is such that when aggregate real income is increased, aggregate consumption is increased, but not by so much as income”.

Proposition of Keynesian Law of Consumption:

The law has three interrelated propositions:

(i) With the rise in income, consumption expenditure also rises but by a smaller amount than the income. This is because as income rises more and more our wants get satisfied.

(ii) The rise in income is distributed between consumption and savings.

(iii) An increase in income therefore always results rise in consumption and savings.

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Assumptions of the Law:

(a) Stability of the consumption function is derived from constant psychological and institutional complex. It means factors like income distributions, habits, tastes, customs, population which influence consumption expenditure do not change.

(b) Normal conditions are assumed to be present. The law does not operate under abnormal conditions like war and inflations.

(c) It assumes the existence of a laissez-faire capitalist economy.

With these assumptions the law is a rough approximation to the actual behaviour of consumers and operates in the short period of time.

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Propensity to Consume: A Schedule(Rs. In Crores)

Income (Y) Consumption (c) Savings (S)

100

200

300

400

500

120

200

280

360

400

-20

00

20

40

100

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From the schedule, when consumption amounting to Rs. 120 crores, it exceeds the income of Rs. 100 crores, which may be met by past savings or from borrowings.

That suggests the minimum expenditure on consumption in the economy initially may exceed the income.

When consumption expenditure equals the income at Rs. 200 crores, it is called the break-even point.

Beyond this point, as income rises, consumption expenditure does not keep pace with the increase in income.

This situation can also be shown by the diagram as follows:

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C2

C1

C

Y1 Y2

B

S2

S1

S3

S

X

Y

O

S

C

consumption

Income

Y=C

s4

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The above chart shows how the total income is distributed among the consumption expenditure and saving.

Curve CC represents the consumption function or propensity to consume.

At OY1 Income, the consumption expenditure is more than the Income and at point B the consumption expenditure OC1 is equal to OY1, which shows the break-even point.

As the income rises to OY2, the consumption expenditure is OC2, but the consumption is less than the income, i.e. C1C2 < Y1Y2.

Hence, the portion of income S1S2 is saved by the community and this is how the consumption function shows the amount of money saved.

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The saving curve SS is also derived from the consumption function.

It shows that when income is less than OY, saving is negative.

At the break-even point, saving is zero and beyond this saving increases with increase in income

It can be seen from the graph that at OY2 income, saving is S1S2 = S3S4.

It is clear from the above analysis that given the propensity to consume, the income is derived between consumption and saving, i.e. Y = f (C, S).

But the important aspect is that the proportion of income devoted to consumption, which in turn influences the level of income and employment.

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Average Propensity to Consume (APC): APC is the ratio of total consumption to the total

income, i.e.

APC = C/Y The nature of APC is that it declines as income

increases, because the proportion of income spent on consumption decreases.

That means the gap between Y and C widens, i.e. the average propensity to save increases as income increases.

This can be better understood by the help of a figure shown below:

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X

Y

A

B

C

C

O

80

90

100 120

Income (Rs.)

Consumption (Rs.)

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The figure shows the average propensity to consume at any one point on the consumption curve CC.

The CC curve is made up of a series of such points and all such points represent the propensity to consume at different levels of income.

At point A, the APC is 80/100 = 80%, and when income rises from 100 to 120, the consumption also increases from 80 to 90, i.e. APC at point B is 90/120 = 75%.

It shows, the total consumption increases when the income increases, but the proportion of income devoted to consumption declines with the increase in income.

Thus, the flattering of the CC curve to the right shows declining APC.

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Marginal Propensity to Consume (MPC): The concept of MPC is considered as an essential

part of general theory of employment. As we know, consumption expenditure is considered

as important determinants of employment, output and income.

So, the MPC shows that additional employment depends on additional consumption when income rises.

Hence, the concept of MPC is important to create the employment in the economy.

MPC: Its is the ratio of the change in consumption to the change in income, symbolically:

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MPC = C/ YWhere, C refers to change in consumption and Y refers to the change in income.

Value of MPC: it is obvious that neither will all the incremental income be consumed, not will it be entirely saved.

If the entire incremental income is consumed then, MPC = C/ Y = 1, and

If, on the other hand, no portion of incremental income is consumed, then MPC = C/ Y = 0

However, in reality, some portion of incremental income will always be consumed. It means that the value of MPC will be greater than zero but less than unity, i.e. MPC >0 but < 1.

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From the MPC, we can derive the marginal propensity to save (MPS), i.e.

MPS = 1- MPC or 1 - C/ Y MPC can be shown diagrammatically as:

Y

X

Y

C90

80

100 120

C

C

A

B

O

Consumption (Rs.)

Income (Rs.)

MPC

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The figure shows, when income rises by Rs. 20/-, consumption increases by Rs. 10/-. Hence the MPC = C/ Y, i.e. 10/20 = 0.5 or 50%Which shows, the MPS is also 50%.

Hence, the marginal propensity to consume is measured by the slope of the CC curve.

Relationship Between APC and MPC: The analysis of APC and MPC shows that –(a) Both decline with an increase in income(b) But, the decline in MPC is greater than the decline in APC.

It is the case of rich communities because most of their basic needs have already been fulfilled. As a result additional income is saved and the MPS rises.

The whole analysis shows that as the real income of the community increases, the consumption also increases but less than the increase in income.

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Factors Determining the Consumption Function:

(a) Subjective or Internal or Endogenous factors

(b) Objective or External or Exogenous factors The subjective factors determine the slope and position of

the consumption function, where as the objective factors determine the shifts in the consumption function, as illustrated by:

O Y Y1

C

C1

C

C

Y

X

Y

X

C

C’

Y

C2

C3

O

Fig: a Fig: b

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Figure (a) shows a change in consumption expenditure because of change in income with no change in propensity to consume.

Where as figure (b) illustrates the change in consumption expenditure caused by changes in the propensity to consume keeping income constant.

Subjective Factors in the Consumption Function:The subjective factors can be grouped into three

classes, such as (a) Psychological characteristics of human nature, (b) Institutional patters and (c) Social practices.

(a) Psychological Factors:There are certain psychological motives which encourage savings and reduce consumption of the household. There are 8 motives in this group:

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(i)(i) Motive of PrecautionMotive of Precaution: Which encourages savings to meet unforeseen emergencies in future.

(ii)(ii) Motive of ForesightMotive of Foresight: Reserves are built to cover anticipated future needs such as old age.

(iii)(iii) Motive of CalculationMotive of Calculation: the desire to enjoy interest.

(iv)(iv) Motive of improvementMotive of improvement: the desire to enjoy the gradually increasing income.

(v)(v) Motive of IndependenceMotive of Independence: The desire enjoy a sense of independence.

(vi)(vi) Motive of enterpriseMotive of enterprise: the desire to establish a business project.

(vii)(vii) Motive of prideMotive of pride: the desire to posses and bequeath wealth.

(viii)(viii)Motive of avariceMotive of avarice: the desire to satisfy miserliness.

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(b) There are certain factors which encourage consumption such as:

Generosity, short-sightedness, enjoyment, Generosity, short-sightedness, enjoyment, miscalculation, extravagance etcmiscalculation, extravagance etc.

(c) There are certain factors which encourages savings in corporate sectors, such as(i) Motive of EnterpriseMotive of Enterprise: the desire to acquire resources to carry out further investment.(ii) Motive of LiquidityMotive of Liquidity: The desire to cope up with emergencies successfully.(iii) Motive of Financial PrudenceMotive of Financial Prudence: to make sufficient financial provision against depreciation.

This shows the psychological and institutional factors determines the decisions whether to consume or save.

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Objective Factors in the Consumption FunctionObjective Factors in the Consumption Function:

There are some important factors which causes shift in the consumption function in the community. These are as follows:

(a)(a) Fiscal Policy:Fiscal Policy: the budgetary policy of the government relating to taxation, public expenditure, public debt, etc., will have significant effects on the consumption function.

Example:Example: Imposition of heavy taxation, diversion of resources during Second World War have depressed the consumption function below its normal condition.

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(b) (b) Changes in the Rate of Interest:Changes in the Rate of Interest: Substantial changes in the rate of interest also alter the propensity to consume. If the rate of interest rises significantly, people will consume less and save more in order to gain from the higher rate of interest.

(c) (c) Changes in Expectation:Changes in Expectation: the expectation regarding future changes especially changes in prices and supply affect to consumption function. This leads people to purchase goods much in excess of current needs. As a result, the ratio of consumption to current income will rise and thereby cause upward shift to consumption function.

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(d) (d) Windfall gains or losses:Windfall gains or losses: The rapid changes in the capital value which occur in the stock market, may increase consumption function.

Example:Example: Recent boom in the stock market has increased the consumption in the hands of people.

(e) (e) Changes in Price LevelChanges in Price Level: this affects in a negative way. A rise in price level reduces the real income in hands of people and hence, they buy less with more money.

(f) (f) Distribution of IncomeDistribution of Income: if there is great inequality in the distribution of income, it lowers the overall propensity to consume. The rich people have low marginal propensity to consume as they have already fulfilled most of their basic wants. A more equal distribution of wealth through fiscal measures by the state will raise the propensity to consume.

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(g) (g) Duesenberry FactorsDuesenberry Factors: Prof. Duesenberry has given two important factors affecting the consumption function, as:

(i)(i) Past standard of LivingPast standard of Living: the consumption expenditure of an individual depends on the current income and the standard of living enjoyed by him in the past. Suppose income falls, the expenditure on income falls less as people fail to make adjustment.

(ii)(ii) Demonstration EffectDemonstration Effect: this shows the consumption standards of low income groups are influenced by the consumption standards of the high income groups. In this case the propensity to consume increases out of a given income.