CONSUMPTION FUNCTION

LECTURE 8
Learning Objectives
1. What is the Keynes consumption theory?
2. What are the properties of consumption
function ?
3. What is the Keynes Saving Function?
4. What are the various consumption theories
evolved after Keynes?
Using the Key Ideas
• Aggregate demand can be obtained by adding up spending:
• C+I+G+X
• Y=C+I + G + X

• BUT WATCH OUT: C depends on Y, because Y is income : example

C = 1000 + .6Y Y =C+I+G+X
• To see the implications of this dependence, put I and X on the backburner for
now
1st Goal: 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”.

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.
Assumptions
1. It assumes a constant Psychological and Institutional complex which
means that income distribution, tastes, habits, social customs, price
movements, population growth etc. remain constant and
consumption depends on income i.e. Short-run Model
2. It assumes the existence of normal conditions. The law does not
operate in abnormal conditions like war, revolution or
hyperinflation.
3. It assumes the existence of lassiez-Fare Capitalist economies and is
in operative in case of socialist economies.
Determinants of Consumption Function
1.Subjective
2.Objective Factors
• Subjective factors ( exogenous or external to the
economic system).
1. Psychological characteristics of human nature. (Foresight,
unforeseen needs, feeling pride, Miserliness)
2. Social practices. (improving standard of living, ostentation
(showoff), Generosity, Rejoicy)
3. Behavior Pattern of Business concerns (improving business,
more earning on interest etc)

On the basis of above characteristics there can be individual as well

as Business Motives.
 Objective Factors ( endogenous or internal to the
economic system).

1. Changes in wage level.

2. Windfall Gains or losses.
3. Changes in the Fiscal Policy.
4. Change in Expectations.
5. Change in Rate of interest
6. Financial policies of Corporations.
7. Distribution of Income
8. Change in Population
A consumption function:
Algebra EXAMPLE: C = Co + c Y
C = 1000 + 0.6Y
or in numerical form: 25_01T

Consumption Income

1,600 1,000
C = Consumption 2,200 2,000
2,800 3,000
Co = Autonomous consumption 3,400 4,000

(Co > 0) 4,000 5,000

4,600 6,000
Y = Income 5,200 7,000

c = Slope of Consumption 5,800

6,400
8,000
9,000
(MPC-Marginal propensity to consume) 7,000 10,000

(0 < c > 1) 7,600 11,000

8,200 12,000
8,800 13,000
9,400 14,000
 Consumption function in
graphical form:
25_04
CONSUMPTION
(BILLIONS OF DOLLARS)

Consumption
function
5,000

4,000

Slope equals marginal

3,000 Change in consumption propensity to
consume.

2,000

Change
in
1,000
Co income
(Autonomous
consumption)
1,000 2,000 3,000 4,000 5,000 6,000
INCOME (BILLIONS OF DOLLARS)
 2nd Goal: Properties of the Consumption Function
1. Marginal Propensity to Consume
It is defined as the ratio of change in consumption to the
change in income.
• It is the rate of change in APC.
MPC= ∆C/ ∆Y
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. (0 < c > 1)
• Economic significance of the MPC lies in filling the gap between income
and consumption through planned investment to maintain the desired
level of income.
The Keynesian consumption function

C  C  cY

c c = MPC
= slope of the
1
consumption
C function

Y
Properties of the Consumption Function
2. The Average Propensity to Consume:
The average propensity to consume may be defined as the ratio of
consumption expenditure to any particular level of income.
• Expressed as percentage or proportion of income consumed.

• APC= C/Y
• APC declines as income increases because the proportion of
income spent on consumption decreases.
The Keynesian consumption function
As income rises, consumers save a bigger
C fraction of their income, so APC falls.

C  C  cY

C C
APC    c
Y Y
slope = APC
Y
 Measures to raise the Propensity to Consume

1. Income Redistribution
2. Increased Wages
3. Social Security Measures
4. Credit Facilities
5. Advertisement
6. Development of the Means of Transport
7. Urbanization
 Early empirical successes:
Results from early studies
• Households with higher incomes:
• consume more,  MPC > 0
• save more,  MPC < 1
• save a larger fraction of their income,
 APC  as Y 
• Very strong correlation between income and
consumption:
 income seemed to be the main
determinant of consumption
 Keynes’s conjectures
1. 0 < MPC < 1
2. Average propensity to consume (APC )
falls as income rises.
(APC = C/Y )
3. Income is the main determinant of
consumption.
 Economic Implications of Keynes Law of
Consumption (MPC < 1)
1. Negation of Say`s Law ( MPC<1----people don`t spend all there income---
unsold goods---overproduction---unemployment)
2. The crucial Importance of Aggregate Demand (unsold goods---
overproduction---unemployment)
3. The turning points of Trade (In boom----income rises----but
consumption do not rise in the same proportion----unsold goods---overproduction-
--unemployment…..Opposite of it in Depression)
4. Over-saving Economy (Non-proportional relationship leads to over-saving
economy)
5. Income Propagation (He presented the concept of investment
multiplier...i.e. change in investment , given the value of MPC, will lead to increase
NI many a times)
3rd Goal: Keynes Saving Function : S = - f (Y)

S = - So + s Y
= - 40 + 0.4 Y
S = Saving
So = Autonomous Saving
(Co > 0)
Y = Income
s = Slope of Saving (MPS- Marginal propensity to Saving) (0 < s > 1)

MPS = ∆S/ ∆Y
APS = S/ Y
Comparison Between MPC & MPS
25_04
CONSUMPTION
(BILLIONS OF DOLLARS)

Consumption
function
5,000

4,000

Slope equals marginal

3,000 Change in consumption propensity to
consume.

2,000
Saving Function
Change
1,000
in Slope equals MPS
income

1,000 2,000 3,000 4,000 5,000 6,000

INCOME (BILLIONS OF DOLLARS)
Relationship Between APC, APS, MPC & MPS

APC + APS = 1
MPC + MPS = 1
MPC = 1- MPS
MPS =1-MPC
 Problems for the Keynesian consumption
function
• Based on the Keynesian consumption function,
economists predicted that C would grow more slowly
than Y over time.
•This prediction did not come true:
•As incomes grew, APC did not fall,
and C grew at the same rate as income.
•Simon Kuznets showed that C/Y was
very stable in long time series data.
The Consumption Puzzle ???????
Consumption function
C from long time series
data (constant APC )

Consumption function
from cross-sectional
household data
(falling APC )

Y
3 rd Goal: Theories of consumption Function
1. Absolute Income Theory
2. Relative Income Hypothesis
3. Long run Income Hypothesis
4. Permanent Income Hypothesis
 1. Absolute Income Theory
• Absolute income theory was presented by JAMES TOBIN & ARTHUR
SMITHIES etc.
• It states that , “ Other things remaining equal, a rise in his absolute income
will lead to a decrease in the function of that income devoted to the
consumption”.
• The supporter of this Theory used cross-sectional data i.e. How spending
effects various income levels of different families. i.e. at different income
slabs.
• Average propensity to consume (aPC) of a family declines as they move up to
a higher income level (during the course of a Year i.e. Short-run)
• Average propensity to consume (aPC) instead of APC i.e. aggregate Average
propensity to consume
 Absolute Income Theory: EXAMPLE
Family Income Family Family aPC = C/Y mPC = ∆C/∆ Y
Class Disposable Consumption
income Expenditure
$ 3000-4000 $ 3487 $ 3570 3570/3487 = 1 -

4000-5000 4462 4450 1 0.9

5000-6000 5449 5257 1 0.8

6000-7500 6618 6043 0.9 0.7

7500-10,000 8434 7108 0.8 0.6

10,000- over 15914 10773 0.7 0.5

Absolute Income Theory: Graphic presentation
C
aPC = 0.90 aPC = 0.80
aPC = 0.70

F aPC = 0.60
G
E
C = f (Y)
D

2 4 6 8 10 12 Yd (000)
SIMON KUZNETS CONTRIBUTION :
(Absolute Consumption Analysis of period 1869-1938)
1. On average , over the long run, the ratio of C/Y or APC
showed no downward trend, so APC = MPC
2. The short run consumption function shows a non-
proportional relationship & pushes the curve forward
up…..because------
i. 1.Increase in accumulated wealth
ii. 2. Urbanization……increase the standard of living .
iii. 3. Increase in health facilities…… longer life span….increase
labor ratio i.e. wage earners
SIMON KUZNETS CONTRIBUTION:
(Shifting for one short run period to another short run period)
LRCF
C
SRCF3
C3
SRCF2

C2
SRCF1

C1

Y1 Y2 Y3 Y
 2. Relative Income Hypothesis
• Relative Income Hypothesis is given by James Duesenberry.
• It states that,
“Consumption and saving do not depend upon the level of
current income. Rather, consumption depends on the relative
position of the individual in the income scale.
In other words, spending are related to a family`s relative
position in the income distribution of approximately similar
family”.
• Based on two assumptions:
A) Consumption behavior of an individual is not independent but
interdependent on other individual( relatives & locality).
B) Consumption Relations are irreversible and not reversible in time.
2. Relative Income Hypothesis
• According to Duesenberry human beings not only try to keep up
with joneses but try to surpass the joneses which shows that
consumers’ preferences are interdependent. Rich people will have a
lower APC and poor people will have higher APC but in long run
APC will remain constant.

• According to Duesenberry it is harder for a family to reduce its

expenditure from a higher level than for a family to refrain from
making high expenditures in the first place.
 1. Relative Income Hypothesis
• The outcome of this statement is that as income falls consumption declines but
proportionately less than decrease in the income because the consumer don`t
saves to sustain consumption.

• Duesenberry consumption function is given by

C = f( Yc, Pp Y)
• Where C --- Consumption
Yc--- Current Income
Pp Y ---- Previous Peak Income

• Ratchet effect is a peculiar phenomenon observed in this case. The short run
consumption function ratchet upwards when income increases in the long run but
it does not shift down to earlier level when income declines.
Relative Income Hypothesis Graphic
Representation
C`
c
L
K
H J
F G C
E
D

Yd
Relative Income Hypothesis
Criticism
• Proportional relationship between consumption and
income is not always true.
• It neglects other factors that influence , consumer
spending such as asset holdings, urbanization,
appearance of new products, etc.
• Expectations and level of aspirations also play an
important role in consumer spending.
 3. The Life-Cycle Hypothesis
• Due to Franco Modigliani (1950s)
• Franco’s model says that consumption depends on
lifetime income, and people try to achieve smooth
consumption.
• The LCH says that income varies systematically over the
phases of the consumer’s “life cycle,”
and saving allows the consumer to achieve smooth
consumption.
 3. The Life-Cycle Hypothesis
• The basic model:
W = initial wealth
Y = annual income until retirement (assumed constant)
R = number of years until retirement
T = lifetime in years
• Assumptions:
• zero real interest rate (for simplicity)
• consumption-smoothing is optimal(max)
Implications of the Life-Cycle Hypothesis
$

The LCH
implies that Wealth
saving varies
systematically
over a person’s Income
lifetime.
Saving

Consumption Dissaving

Retirement End
begins of life
CHAPTER 16 Consumption
 3. The Life-Cycle Hypothesis
• Lifetime resources = W + RY
• To achieve smooth consumption,
consumer divides his resources equally over time:
C = (W + RY )/T , or
C = aW + b Y
where
a = (1/T ) is the marginal propensity to
consume out of wealth
b = (R/T ) is the marginal propensity to consume out of income
 Implications of the Life-Cycle Hypothesis
The LCH can solve the consumption puzzle:
• The life-cycle consumption function implies
APC = C/Y = a(W/Y ) + b
• Across households, income varies more than wealth, so high-
income households should have a lower APC than low-income
households.
• Over time, aggregate wealth and income grow together,
causing APC to remain stable.
 4. The Permanent Income Hypothesis
• According to Milton Friedman (1957)
Y = YP + YT
where
Y = Current income
Y P = Permanent income
average income, which people expect to persist into the
future
Y T = Transitory income
temporary deviations from average income[Bonuses (+ve,
Y P ↑), Unemployment (-ve, Y P ↓)]
 4. The Permanent Income Hypothesis(PIH)
• Consumers use saving & borrowing to smooth consumption
in response to transitory changes in income.
• The PIH consumption function:
C =aYP
where a is the fraction of permanent income that people
consume per year.
 4. The Permanent Income Hypothesis
The PIH can solve the consumption puzzle:
• The PIH implies
APC = C / Y = a Y P/ Y
• If high-income households have higher transitory income
than low-income households,
APC is lower in high-income households.
• Over the long run, income variation is due mainly (if not
solely) to variation in permanent income, which implies a
stable APC.
 PIH vs. LCH
• Both: people try to smooth their consumption
in the face of changing current income.
• LCH: current income changes systematically
as people move through their life cycle.
• PIH: current income is subject to random, transitory
fluctuations.
• Both can explain the consumption puzzle.
Review
We have learned about:
• The Keynes Income theory
• The average and marginal propensity to consume
• The relative Income theory
• The long run Income Hypothesis
• The permanent Income Hypothesis
THANK YOU
2 nd
QUIZ of CH-3 & CH-4 on Friday- 5 th

March 2015