CONSUMPTION FUNCTION:

“Consumption is the sole end and purpose of all production.” - (Smith, 1776, p. 363) 

Consumption refers to the final purchase of goods and services by individuals or households. A deep study of consumption is important for two significant reasons.

Firstly, consumption is a major constituent of aggregate demand and accounts for 58% (Database on Indian Economy, RBI, 2014-15) of the aggregate demand and thus it is important to understand what determines consumption. Secondly, income that is not consumed is saved and savings have a huge bearing on the growth of an economy. GDP of an economy as the name suggests is the sum total of goods and services produced and the yearly growth rate of GDP is the major yardstick or benchmark to judge the economic growth of the country. The major constituents of the GDP growth are (a) Consumption, (b) Government Spending, (c) Investments (d) Net exports. Out of all these factors responsible for GDP growth, consumption is dominant part contributing to GDP growth.

GDP = C + I + G + (X-M) 

where, C = Consumption, I = Investment, G = Government Spending, X= Export and M = Import

CONCEPTUAL FRAMEWORK OF KEYNES CONSUMPTION FUNCTION :

 Concept of Consumption Function The consumption function refers to income consumption relationship. It is a “functional relationship between two aggregates, i.e., total consumption and gross national income.” Symbolically, the relationship is represented as, C= f (Y), where ? is consumption, Y is income, and f is the functional relationship. Thus the consumption function indicates a functional relationship between ? and Y, where ? is the dependent and Y is the independent variable, i.e., ? is determined by Y. This relationship is based on the ceteris paribus (other things being equal) assumption, as such only income consumption relationship is considered and all possible influences on consumption are held constant. 

 Properties or Technical Attributes of the Consumption Function The consumption function has two technical attributes or properties:

(i) the average propensity to consume (APC), and

(ii) the marginal propensity to consume (MPC). 

Average Propensity to Consume

“The average propensity to consume may be defined as the ratio of consumption expenditure to any particular level of income.” It is found by dividing consumption expenditure by income, or APC = C/Y, where C = Consumption and Y = Income. It is expressed as the percentage or proportion of income consumed. 

Table 2.1 shows the APC at various income levels. The APC declines as income increases because the proportion of income spent on consumption decreases. If consumption expenditure is Rs. 200 and income is also Rs. 200, then APC = C/Y or 200/200 = 1, i.e. 100% of the income is spent on consumption. But reverse is the case with average propensity to save (APS) which increases with increase in income. Thus the APC also tells us about the APS, APS=1-APC.  Diagrammatically, the average propensity to consume is C/Y, as shown in Figure 2.2. Income is measured on X-axis and consumption is measured on Y-axis. CC is the consumption curve. At point N on the consumption curve CC, APC = OM/OY₁.

Figure 2.2 Measurement of Average Propensity to Consume 

 

 Marginal Propensity to Consume “The marginal propensity to consume may be defined as the ratio of the change in consumption to the change in income or as the rate of change in the average propensity to consume as income changes.” It can be found by dividing change in consumption by a change in income, or MPC = C/Y, where denotes change (increase or decrease), C = Consumption and Y = Income. Table 2.1 shows that the marginal propensity to consume (MPC) is constant at all levels of income. It is 0.8 or 80% because the ratio of change in consumption to change in income is C/Y = 80/100. The marginal propensity to save (MPS) can be derived from the MPC by the formula 1 - MPC. It is 0.2 in our example. Diagrammatically, the marginal propensity to consume is measured by the slope of the C? curve. This is shown in Figure 2.3. The marginal propensity to consume is MP/Y₁Y₂, where MP is change in consumption (C) and Y₁Y₂ is change in income (Y). 

Figure 2.3 Measurement of Marginal Propensity Consume

 Keynes Psychological Law of Consumption 

Keynes in his book “The General Theory of Employment, Interest and Money,” 1936, postulated that aggregate consumption is a function of aggregate current disposable income. Keynes emphasized on absolute size of income as a determinant of consumption, his theory of consumption is also known as absolute income theory. The relation between consumption and income is based on his fundamental psychological law of consumption which states that when income increases, consumption expenditure also increase but by a somewhat smaller amount. “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” (Keynes, 1936). Further Keynes in his General Theory of Employment, Interest and Money (1936) remarked, “The fundamental psychological law upon which we are entitled to depend with great confidence both a prior from our knowledge of human nature and from the detailed facts of experience, is 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 incomes”. This law was popularly known as ‘Propensity to Consume’ and subsequent writers called it ‘Consumption Function.’ 

Keynes’ Psychological Law of Consumption: Three Related Propositions 

Proposition 1: “When the aggregate income increases, consumption expenditure also increases but by a somewhat smaller amount. The cause is that as income increases, our wants have already been satisfied side by side, so there is less need to increase consumption in proportion to the increase in income. It means consumption expenditure will increase by somewhat smaller amount with increase in income.” This proportion shows, C < Y.

Proposition 2: “An increase in income is divided in some proportion between consumption expenditure and saving. It means that income increases will either be consumed or saved. This proposition follows the above proposition, as what is not spent on consumption is saved.”

Proposition 3: “With the increase in income both consumption spending and saving go up. This means that increase in income is unlikely to lead either to fall in consumption or saving than before it, therefore, emphasizes the short run stability of the consumption function.”

 Figure 2.3 Summary of Keynes’ Three Propositions

Explanation with the help of schedule and diagram. The three proposition of the law can be explained with the help of an example presented in Table 2.2.

Table 2.2 Proposition of Keynes’ Law

 

Proposition 1: Income increases by Rs. 100 crores and the increase in consumption is by Rs 80 crores. The consumption expenditure increases from Rs. 280 to 360, 440 and 520 crores against increase in income from Rs. 300 to 400, 500 and 600 crores. Hence, C < Y.

Proposition 2: The increased income of Rs 100 crores in each case is divided in some proportion between consumption and saving (i.e. Rs 80 crores and Rs 20 crores).

Proposition 3: As income increases from Rs. 200 to 300, 400, 500 and 600 consumption also increases from Rs. 200 to 280, 360, 440, 520 crores, along with increase in saving from Rs. 0 to 20, 40, 60 and 80 crores respectively. With increase in income neither consumption nor saving have fallen.

The three propositions are explained diagrammatically with the help of Figure 2.4. Here, income is measured on X-axis and consumption and saving are on Y-axis. C is the consumption function curve and 45^o line where Y = C.

Proposition 1: When income increases from OY₁ to OY₂ consumption also increases from BY₁ to C₁Y₂ but the increase in consumption is less than the increase in income, i.e., C₁Y₂ < A₁Y₂ (= OY₂) by A₁C₁

Figure 2.4 Keynes’ Three Propositions.

 

Proposition 2: When income increases to OY₂ and OY₃, it is divided in some proportion between consumption C₁ Y₂ and C₂Y₃ and saving A₁C₁ and A₂C₂ respectively.

Proposition 3: Increase in income from OY₂ to OY₃ lead to increased consumption C₂Y₃ > C₁Y₂ and increased saving A₂C₂ > A₁C₁ than before. It is clear from the widening area below the C curve and the saving gap between 45^o line and the C curve. 

 Keynes Conjectures

Keynes wrote in the 1930, at that time and its didn’t have the advantage of the data nor the computers necessary to analyses data sets. Keynes “discovered” this law not by statistical analysis of data (there were no time series of national income and product data at that time) but simply by casual observation and introspection. But today, economists study is based on sophisticated techniques of data analysis. They analyses aggregate data from the national income accounts and from surveys with the help of computers and statistical software. Following are the conjectures made by Keynes. 

Conjecture 1

Regarding the marginal propensity to consume (MPC), he conjectured that MPC is between 0 and 1 (0 < MPC < 1), where MPC is “the additional amount of consumption from additional amount of income.” If an individual’s income increases, then he will spend a part of the incremental income and save some.

Conjecture 2

Keynes assumed that the average propensity to consume (APC), which is “the ratio of consumption to income decreases with an increase in income.” He considered saving as a luxury which could be afforded by the higher income groups. Thus he expected APC to fall with rise in income.

Conjecture 3

Keynes considered income as the primary determinant of consumption, further he thought that interest rate does not have a bearing on consumption. Knowing that higher interest rates encourage savings and discourage consumption, he admitted that theoretically interest rate could influence consumption. He noted that, “the main conclusion suggested by experience, I think, is that the short-period influence of the rate of interest on individual spending out of a given income is secondary and relatively unimportant” (Keynes, 1936). On the basis of above conjectures Keynes consumption function is written as: C = a + bY, a > 0, 0 < b < 1 Where C is the consumption expenditure, Y is the disposable income, ‘a’ is the intercept term, a constant which measures consumption at a zero level of disposal income. Thus ‘a’ is autonomous consumption. The parameter ‘b’ is the marginal propensity to consume (MPC), which measure the increase in consumption spending in response to per unit increase in disposable income. Graphically this consumption function can be represented as a straight line, as shown in Figure 2.5.

Figure 2.5 Keynes Consumption Function

Conjecture 1   Keynes’s first conjecture that marginal propensity to consume is between 0 and 1 is satisfied by the above graph. Thus with a rise in income, consumption and savings both will increase. 

Conjecture 2   The said figure satisfies Keynes’s second conjecture, the average propensity to consume falls with the rise in income. As shown in the graph, APC = C/Y = a/Y + b (C = a + bY). As income rises a/Y falls leading to a fall in the APC.

Conjecture 3   And finally, this consumption function satisfies Keynes’s third conjecture because Keynes identifies income as the only determinant of consumption and disregards interest rate as the determinant. 

 Assumptions of Keynes Consumption Function Keynes's Law is based on the following assumptions:

Stable Psychological and Institutional Factors : This law assumes that the psychological and institutional factors like social customs, population growth, tastes, price movements, habit, etc. influencing consumption expenditure remain constant. These factors do not change in the short run and income is the only determinant of consumption. The fundamental cause of the stable consumption function is the constancy of these factors.

 Normal Conditions : The law holds well under normal conditions but under abnormal and extraordinary circumstances like hyperinflation, war or revolution, the law will not operate. People may spend the whole of increased income on consumption.

 Laissez Faire Economy :The French term 'Laissez Faire' means 'leave alone'. The term refers to an economic system where the transactions among private parties are free of government intervention. The government invention could be the form of licensing, subsidies or tariffs. The idea was that in free market capitalism the less the government intervention the better it would be for businesses and put collectively the society as a whole would be better off. As a law, it's essentially operative only in capitalist economies and breaks down in socialist or regulated economies.

Figure 2.6 Summary of the Assumptions of Keynes Consumption Function

Professor Kurihara opines that “Keynes’s law based on these assumptions may be regarded as a rough approximation to the actual macro-behaviour of free consumers in the normal short period”

 Implication of Psychological Law of Consumption or Importance of Keynes’s Law,

According to Prof. A.H. Hansen (1946, p. 183), “Consumption function is an epoch making contribution to the tools of economic analysis, analogous to, but even more important than, Marshall’s discovery of the demand function”. Keynes's psychological law underscores the importance of the consumption function since the latter is, based on the former. It has immensely important – both theoretically and practically. All countries, work towards removing unemployment, raising national income and enjoying prosperity. A well planned economic development policy is essential to meet this purpose.

Say’s Law of Market:   Say’s law of markets which is the fundamental basis of classical theory of income and employment, states that “Supply creates its own demand”. Hence, there is no scenario of unemployment and over production. Consumption function establishes that the increase in additional income does not fully result into increase in consumption goods. Hence, according to Keynes, “supply does not create its own demand.” Instead, it very often exceeds it and creates a surplus of goods which causes over production and mass unemployment.

 Role of Investment in Employment Theory : According to Keynes, employment level can be increased by raising consumption and investment. But consumption function in the short term remains almost constant and hence may be assumed as given. Thus, investment is the vital factor in determining the employment level. 

Turning Points of the Business Cycle :  During the economic boom period, despite an increase in income, consumption expenditure does not increase in the same proportion. Hence, there is a rise in savings and decline in demand which correspondingly leads to a period of economic downturn. Similarly, during the period of slump, while there is a decline in income, expenditure on consumption does not decline to the full extent of the fall in incomes. This leads to period of economic boom.

Tendency of Marginal Efficiency of Capital : In rich advanced countries, the Marginal Propensity to Consume (MPC) is < 1. Hence, Marginal Efficiency of Capital (MEC) shows a downward trend. This is because as income increases, expenditure declines, savings increase, demand drops, production declines, profits fall – ultimately resulting in a decline in MEC. Hence, economic growth declines with a decline in investment. 

 Secular Stagnation :  Typically, the MPC is low and Marginal Propensity to Save (MPS) is high in most of the developed nations. The gap between income and consumption continues to increase compelling an increase in investment. Similar to the propensity to consume, propensity to save also tends to be stable and reduces over time. Thus, the economy will come to a stage where it will be unable to fully and effectively use its savings for promoting full employment. Keynes refers to this as “Secular Stagnation”.

Value of Multiplier : Multiplier’s value is derived from consumption function. K = 1/1-MPC or 1/MPS. This helps us understand the multiplier effect. Since the MPC is less than 1, the increase in national income is not directly equal to the investment. The multiplier effect declines when consumption expenditure drops in an economy.

Under-Employment Equilibrium: Since MPC is less than unity, the consumers do not spend the full increase in income on consumption. Effective demand becomes insufficient to lead to a full employment equilibrium. Thus, the economy remains at under employment. 

 State Intervention. The economy is not self-adjusting to the situations that arises from lack of consumption like over production and unemployment. Hence, government intervention becomes indispensable. Thus, consumption function helps us to analyse the income generation process, growth in employment levels, need for the government involvement and a very high level of investment to maintain national income and employment.

 

 Determinants of Consumption Function

Keynes refers two primary factors which influence the consumption function and define its slope and position. These are subjective and objective factors. The subjective factors are internal or endogenous to the economic system, they include psychological features of the human nature, social arrangements and social practices and institutions. They “are unlikely to undergo a material change over a short period of time except in abnormal or revolutionary circumstances.” They therefore, determine the slope and position of the ? curve which is almost stable in the short-run (Keynes, 1936). 

The objective factors are external or exogenous to the economic system. These factors may experience swift changes and may cause noticeable shifts in the consumption function (i.e., the C curve).

Subjective Factors

The subjective factors can further be studied under Individual and Business motives. 

 Individual Motives: There are eight motives “which refrain individuals from spending out of their incomes.” They are:

(i) The desire to accumulate funds for unexpected contingencies;

(ii) The desire to make provisions for expected future needs, i.e., old age, sickness, etc.;

(iii) The desire to enjoy a large future income through interest and appreciation;

(iv) The desire to improve the standard of living by gradually increasing expenditure;

(v) The desire to enjoy a sense of independence and power to do things;

(vi) The desire to secure a “masse de manoeuver” to undertake speculative or business projects;

(vii) The desire to pass on a fortune; and

(viii) The desire to fulfil a pure miserly instinct. 

Business Motives: Keynes lists four motives for accretion on their part:

(i) Enterprise – the desire to expand business and do big things;

(ii) Liquidity – the desire to meet contingencies and problems;

(iii) Income raise/Bonus – the desire to accumulate large income and highlight the efficiency and effectiveness of the management;

(iv) Financial prudence – the desire to provide sufficient financial resources to offset depreciation and obsolescence, and to repay debt; These factors see less variations and are fairly constant during the short-term, which in turn keeps the consumption function stable. In the words of Keynes (1936), “Those psychological characteristics of human nature and those social practices and institutions which, though not unalterable, are unlikely to undergo a material change over a short period of time except in abnormal or revolutionary circumstances.” 

 Objective Factors

Objective factors are subject to quick changes and lead to significant shifts in the consumption function, they are as below:

Windfall Gains or Losses:  Consumption level of people may change suddenly when they realize windfall gains or losses. For example, the post-war windfall gains in stock markets seem to have raised the consumption spending of rich people in the U.S.A., and correspondingly, the consumption function shifted upwards.

 Fiscal Policy: The propensity to consume is also impacted by changes in fiscal policy of the government. For instance, levy of heavy taxes tends to lower the disposable real income of people; so consumption level may adversely change. Conversely, withdrawal of certain taxes may lead to an upward shift of consumption function. 

 Change in Expectations: The propensity to consume is also impacted by prospective changes. For example, an anticipated war substantially influences consumption by building fears regarding future scarcity and rising prices. This leads to hoarding as people buy more than they immediately need. Thus, the ratio of consumption to current income will increase, implying that the consumption function will be shifted upwards. 

The Rate of Interest In the long term, considerable changes in the market rate of interest may also impact consumption. A significant increase in the rate of interest may encourage people to take advantage of the higher interest rate and save more, thereby reducing the consumption at each income level. Moreover, if the interest rate increases, then the lending of the current savings (realised from lower consumption) will allow one to obtain an even greater quantity of consumption goods in the future. Keynes, thus, argues that “Over a long period, substantial changes in the rate of interest probably tend to modify social habits considerably.”

In addition to above factors, Keynes also referred to changes in wage levels, in accounting practices with respect to depreciation (indicating the difference between income and net income), as the objective factors affecting the consumption function.

Keynes’ followers, however considered his set of objective factors as inadequate and included additional factors as mentioned below: 

1. The Distribution of Income

With a given level of income, total consumption will vary if income is distributed differently among the people. A community with a high unequal distribution of income is likely to have an overall low propensity to consume, while a high degree of equality of income will generally have a high propensity to consume. Thus, propensity to consume is affected by the redistribution of income through fiscal measures of the State. Joan Robinson explicitly states that “the most important influence on the demand for consumption goods is the distribution of income.” Keynes does not call out income distribution as an objective factor, rather includes it under the common heading of fiscal policy. 

2. Holding of Saving-Liquid Assets

According to Kurihara, “Volume of total savings is another factor affecting the consumption function” (as cited in Jain and Khanna, 2007). Greater the savings (i.e., liquid assets, like cash balances, savings accounts and government bonds), the more likely that people will likely spend out of their current income, since the holding of savings in the form of liquid assets, will provide them with a greater sense of security. A change in the real value of these liquid assets, due to changes in market prices, might also impact the consumption function.

3. Corporate Financial Policies

Kurihara points out that that business policies of companies in relation with income retention, dividend payments, and re-investments, lead to some changes in the propensity to consume of equity shareholders. A conservative dividend policy followed by companies will lower the consumption function by reducing the residual disposable income of shareholders (who are the actual consumers). All the aforementioned factors will affect the consumption function positively or negatively. However, all of them are relatively stable in the normal short term and, therefore, cannot explain the changes in aggregate consumption in the short term. Income is the only variable which will change noticeably in the short term and affect consumption. Thus, it may be asserted that consumption varies only with the changes in income levels. 

 Empirical Study of Consumption Function 

The Early Empirical Successes Shortly after Keynes proposed the consumption function and its conjectures, economists and statisticians took up the task of empirically verifying its propositions. They conducted primary research whereby they surveyed, collected, interpreted and analyse data collected from households. As part of their research they focused on consumption, savings and income patterns and propensities. The findings of these research were as follows:

1. Household units with higher income consumed more, confirming that MPC > 0.

2. Household units with higher income saved more, confirming that MPC < 1.

3. Household units with higher income saved larger proportion of their income, confirming that APC falls with rise in income. 4. Very strong correlation between income and consumption and income seemed to be the main determinant of consumption. Thus Keynes’s proposition met with initial empirical success.

 Empirical Contradictions Although the Keynesian consumption function was empirically confirmed by initial studies, but it was soon confronted with anomalies. These anomalies are concerned with the Keynes’s conjecture that the average propensity to consume falls as income rises. The first exception was noticed during World War II, when some economists, based on Keynesian consumption function feared that consumption would grow more slowly than income over time resulting in decline in the average propensity to consume. Higher savings rates (lower APC) could mean a lack of aggregate demand and a return to the depression-like conditions before the war. In other words, these economists envisaged that the economy would experience what they called secular stagnation - a long depression of indefinite duration. To overcome from this situation government needed to make up the spending deficit with fiscal expansions. Providentially, this prediction did not come true. After the war, as incomes grew, average propensity to consume did not fall and consumption grew at the same rate as income, means savings rates did not rise as incomes rose. So, Keynes’s conjecture that average propensity to consume would fall as income increases did not hold. This was in favour of the economy, but against the Keynesian consumption function. 

The Consumption Puzzle – Simon Kuznets 

Noted American economist Simon Kuznets conducted empirical studies regarding consumption of the US economy for the period 1869-1938. His study was based on a cross-section of household budget data over long term time-series data. The study revealed that while the findings of Keynes’ consumption function were correct over the short term, in the long term there were contradictions. These contradictions in the economic circles are often referred to as the “Consumption Function Puzzle.” Several economists attempted to resolve this puzzle and in process also put forward new theories to explain the puzzle. 

Kuznets’ Consumption Function As seen, Keynes represented the consumption function as ‘C = a + bY’, stating that even at zero income level there will be certain consumption financed by dissavings or borrowings. Thus the average propensity to consume would also reduce as income rose. On the other hand, Kuznets found that consumption function is of the following form, ‘C = bY’, where C = consumption, b = marginal propensity to consume and Y = Income Note that in Kuznets’ consumption function there exists no autonomous consumption or intercept term. As shown in Figure 2.7 Kuznets’ consumption function curve begins from the origin and is quite close to 45° line depicting high propensity to consume (b). For the period 1869-1933 Kuznets with his empirical study estimated that the average propensity to consume was nearly 0.9 (Alimi, 2013, p. 4). Further, by dividing the entire period (1869-1933) into three overlapping thirty years sub-periods Kuznets found that average propensity to consume was almost the same at about 0.87 in all the three sub periods. Thus Kuznets concluded that there was no tendency for the average propensity to consume to decline as disposable income rises. Therefore, rounding off Kuznets findings the estimated propensity to consume is 0.9. His consumption function can be rewritten as C = 0.9Y.

Figure 2.7 Kuznets’ Consumption Function 

Consumption function of Keynes (C = a + bY) and Kuznets (C = bY) are different in two aspects. Firstly, as per Keynes’ consumption function APC falls as income rises whereas in Kuznets ‘consumption function APC remains constant over a long period. Further, the marginal propensity to consume (MPC), is significantly higher in Kuznets’ function when compared to that of Keynes. In reconciliation of the two consumption functions economists have observed that while Keynes’ function is a short run consumption function, ‘Kuznets’ function is concerned with long run and thus has been referred to as long run consumption function.