6.1 consumption function

macroeconomics: consumption function

1. Unit 6: consumption function Meaning Consumption function Linear consumption function Kyenes ’ Psychological law of consumption function Consumption function in short run and long run Average Propensity to consume (APC) Marginal Propensity to consume (APC ) Relationship between APC and MPC Factors affecting Consumption Function Measures to raise propensity to consume Implication of consumption function

2. What is consumption? Consumption is the use of final goods and services to satisfy needs (wants) Consumption is the process of satisfying human wants. We make expenditure on goods and services which are needed to meet our wants.

3. Consumption Function A function showing how the relationship between consumption and its determinants ( mainly income) Consumption function 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. Propensity to consume does not mean a mere desire to consume, but the actual consumption that place or is expected to take place out of varying amount.--------- K.K. Kurihara Consumption function is nothing more than a statement of the relationship between consumption expenditure and income …R.G. Lipsey.

4. Consumption Function The consumption function or propensity to consume means the functional relationship between total consumption and gross income. Mathematically, C= f(Y) where C= consumption expenditure f=function, Y= income

5. Linear consumption function if the slope of consumtion curve remains constant throughout its length it is said to be linear consumption function. Mathematically: C= a+bYd Where ; a=autonomous consumption b=Marginal propensity to consume Yd =disposable income

6. National Income (in Rs.) Consumption C = 50+0.5Yd Saving (in Rs.) S = Yd -C 50+0.5*0=50 -50 100 50+0.5*100=100 200 50+0.5*200=150 50 300 50+0.5*300=200 100 400 50+0.5*400=250 150

7. DISPOSABLE INCOME Consumption

8. Keynes’Psychological Law of Consumption Keynes propounded the psychological law of consumption which provides foundation to consumption function. This law explains the nature of propensity to consume or the nature of functional relationship between consumption and income. This law states that people have tendency of spending less proportion of increase income on consumption. According to Keynes, “ The psychology of the community is such that when aggregate real income increases, aggregate consumption also increases but not as much as in income ”.

9. Psychological Law of Consumption

10. This law is based on following propositions Proposition 1: When aggregate income increases , consumption expenditure also increases but by a smaller amount. It means: ∆ C<∆Y Where; ∆ C = change in consumption ∆Y = change in income Proposition 2: The increased income will be divided in some ration between consumption and saving ie , ∆ Y = ∆ C + ∆S Proposition 3: When income increased both consumption and saving also increase.

11. Assumptions No change in factors like desire, behavior, fashion, population etc. No government intervention(capitalist economy). Normal situation in the economy( no war, natural disaster etc ) No change in price etc.

12. Importance/Implication of Psychological law of consumption Makes Say’s law invalid Need for Government Intervention Existence of Underemployment Basis of theory of multiplier Nature of Marginal Efficiency of Capital

13. Consumption function in short run and long run Historical data shows , consumption rises and falls cyclically ( shortrun ) less than in proportion to the rise and fall in income In longrun , the consumption function doesn't remain constant Empirical study done by Kuznet shows that consumption expenditure increase in the same proportion as increase in income

14. Properties of MPC MPC is greater than 0 and less than 1. 0‹MPC‹1 Poor people have higher MPC and Rich people have lower MPC. MPC in short run is stable because psychological factors/ institutional factors do not change in short run.

15. Calculation of APC and MPC Income (Y) Consumption (C) APC = C/Y MPC = ∆C/∆Y 200 200 200/200 = 1 (100%) 80/100 = 0.8 (80%) 300 280 280/300 = 0.93 (93%) 400 360 500 440 600 520 700 600 800 680

16. Calculate APC and MPC

17. Relationship between APC and MPC APC is the ratio of consumption expenditure to income level whereas MPC is the ratio of change in consumption expenditure to change in income level. APC=C/Y MPC=∆C/∆Y When consumption function is linear, as income increases, APC falls and MPC remains constant. When consumption function is non-linear, as income increases, both APC and MPC fall but MPC falls faster than APC. APC is related to long-run analysis whereas MPC is related to short-run analysis. APC=1-APS MPC=1-MPS

18. Determinants of consumption Function 1. Subjective Factors (endogenous/internal factors) Psychology of human nature According to Keynes, the psychological factors determine the slope and position of consumption function. Human values, social practices etc. affect consumption. People want to reserve for unseen contingencies, future need, enjoy enlarge future income from investment, be independent, to possess power and dignity, to carry speculative activities, to satisfy miserly nature. II. Institutional Arrangement: Desire to expand business, Liquidity, Demonstrate successful management, financial care etc.

19. Determinants of consumption Function 2 . Objective Factors (exogenous/external factors) Change in wage level Distribution of income Windfall gain and loss Fiscal policy Changes in expectations Financial policies of organization Holding liquidity assets Dusenberry hypothesis: past living standard and demonstration effect Attitude towards Thrift Social security(pf, insurance) Installment buying New Products