CONSUMPTION FUNCTION

Introduction

This chapter is deals with the various factors which determine the levels of national
income and employment. As we have seen, given the aggregate supply, the level of
income or employment is determined by the level of aggregate demand; the greater the
aggregate demand, the greater the level of income and employment and vice versa.
Keynes was not interested in the factors determining the aggregate supply since he was
concerned with the short run and the existing productive capacity. Aggregate demand
consists of two parts-consumption demand and investment demand. In this chapter we
will explain the consumption demand and the factors on which it depends and how it
changes over a period of time. Consumption demand depends upon the level of income
and the propensity to consume. We shall explain below the meaning of the
consumption function and the factors on which it depends.

Factors affecting consumption Function

The distinction between consumption and consumption function will make the
meaning of consumption function clear. Consumption means the amount spent on
consumption at a given level of income, but consumption function or propensity to
consume means the whole of the schedule showing consumption expenditure at various
levels of income. It means how consumption expenditure increases as income increases.
The consumption function or propensity to consume, therefore, indicates a functional
relationship between two aggregates, viz., total consumption expenditure and the gross
national income. It is a schedule that expresses relationship between consumption and
disposable income.

Propensity to Consume

Propensity to Consume means the relationship between income and consumption,

i.e. propensity consume is also called “consumption function”. Aggregate consumption
depends on consumption function (or) propensity to consume.

Consumption means the amount spent on consumption at a given level of income.

The factors influenced consumption are ;

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 (a) the real income of the individual,

(b) his past savings

(c) Rate of interest consumption function (or) propensity to consume means

how consumption expenditure increases as income increases.

Consumption demand depends on income and propensity to consume.

Propensity to consume depends on various factors such as price level, interest rate,
stock of wealth and other subjective factors.

Average and Marginal Propensity to Consume:

There are two important concepts of propensity to consume (1) Average propensity to
consume and (2) marginal Propensity to consume

Average Propensity to Consume

The average propensity to consume is a relationship between total consumption and

total income in a given period of time. Therefore, average propensity to consume is
calculated by dividing the amount of consumption by the total income.

C
APC ,where Y

APC stands for average propensity to consume C for

amount of consumption, and Y for the level of income.

Average propensity consume is the ratio of consumption to income.

For example.

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 Consumption (C)

Income (Y) = = = 0.8

Y
Y

C
850
R
800 800

C
C

0 X 0 X

Marginal Propensity to Consume

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The marginal propensity to consume measures the incremental change in consumption
as a result of a given increment in income-is how much consumed and how much
saved. Marginal propensity to consume is the ratio of change in consumption of the
change in income. Thus:

C
MPC =
Y

Where, MPC stands for marginal propensity to consume C for

change in consumption, and

for change in income.

For example, the table 7.1 shows that the marginal propensity to consume at
various levels of income. In this schedule when income rises from Rs. 1000/- crores to
Rs. 1100/- crores, the consumption increases from Rs. 950 crores to Rs. 1040 crores.
Here the increment in consumption is Rs. 90/- crores. Therefore marginal propensity to

C 90
consume which is is here equal to or 0.9.
Y 100

Concept of Consumption Function

As the demand for a good depends upon its price, similarly consumption of a
community depends upon the level of income. In other words, consumption is a
function of income. The consumption function relates the amount of consumption to the
level of income. When the income of a community rises, consumption also rises. How
much consumption rises in response to a given increase in income depends upon the
propensity to consume or consumption function. It should be borne in mind that the
consumption function or the propensity to consume is the whole schedule which
describes the amounts of consumption at various levels of income. We give below such
a schedule of consumption function.

Consumption function should be carefully distinguished from the amount of

consumption. By consumption function is meant the whole schedule which shows
consumption at various levels of income, whereas amount of consumption means the
amount consumed at a specific level of income. The schedule described above reflects

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the propensity to consume of a community i.e., it indicates how the consumption
changes in response to the change in income. In the above schedule it will be seen that
at the level of income equal to Rs. 1200 crores, the amount of consumption is Rs. 900
crores. As the national income increases to Rs. 1500 crores, the consumption rises to
Rs. 1125 crores. Thus, with the given propensity to consume or consumption function,
amount of consumption is different at different levels of income.

7.1 Consumption Function Schedule

Income
(Rs. In Consumption Average Propensity to Marginal propensity
crores) (Rs. In crores) consume to consume

C C
Y C Y
Y

750
1000 750 0.75 -
1000
825 75
1100 825 0.75 .75
1100 100

1200 900 900 0.75 75 .75

1200 100

1300 975 75
975 0.75 .75
1300 100

1050 75
1400 1050 0.75 .75
1400 100

1125 75
1500 1125 0.75 .75
1500 100

1200 75
1600 1200 0.75 .75
1600 100

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The above schedule of consumption function reveals an important fact that when
income rises, consumption also rises but not as much as the increase in income.

This fact about consumption function was emphasized by Keynes, who first of all
evolved the concept of consumption function. The reason why consumption rises less
than increases in income is that a part of increment in income saved. Therefore, we see
that when income increases from Rs. 1000 crores to Rs. 1100 crores, the amount of
consumption rises from Rs. 750 crores to 825 crores. Thus, with the increase in income
by Rs. 100 crores, consumption rises by Rs. 75 crores; the remaining Rs. 25 crores is
saved. Similarly, when income rises from Rs. 1100 crores to Rs. 1200 crores, the
amount of consumption increases from Rs. 825 crores to Rs. 900 crores. Here also, as a
result of increase in income by Rs. 100, the amount of consumption has risen by Rs. 75
crores and the remaining Rs. 25 crores has been saved. The same applies to further
increases in income and consumption. We shall see later that Keynes based his theory
of multiplier on the proposition that consumption increases less than income and his
theory of multiplier occupies an important place in macroeconomics.

Factors affecting Consumption Function

The factors that determining consumption function are of two types, (a)
Objectives factors; (b) Subjective factors.

Objective Factors

1. Distribution of Income

This is an important factor determining the propensities to consume. Normally the

average and marginal propensities to consume of the poor people are higher than those
of the rich. This is because the poor have a lot of unsatisfied wants and are likely to
spend every additional unit of money that they obtained in satisfying their wants. In
contrast, the rich have a high standard of living and relatively less urgent wants remain
to be satisfied. Additional income in their case is more likely to be saved. Hence, the
more equal the consume.

2. Fiscal Policy

The Fiscal Policy of the government is related to taxation. Expenditure and public debt
affects the propensity to consume. A reduction in taxation will leave more post – tax
incomes with people which would tend to increase their expenditure on consumption.
In
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contrast, an increase in taxation will decrease consumption. A highly progressive tax
system decreases inequalities in the distribution of income which increases the
propensity to consume.

3. Financial Policies of Corporations

If corporations and companies retain more reserves and distribute lesser profits in the
form of dividends, the disposable incomes of the share holders will be smaller.
In contrast if more profits are distributed more will be spent on consumption.

4. Change in Expectations

If the consumers expect a shortage or rise in prices of certain goods they may rush to
purchase such goods in excess of their current needs. This would raise the consumption
function. On the other hand, if the people expect a decline in price they would tend to
postpone purchases of such goods which would lower the consumption function.

The consumption of a person is also influenced by expectation as to what his income

will be in the future. If he expects an increases in income in future he will tend to
consume more.

5. Windfall Gains or Losses

Sudden and unexpected gains and losses in income affect consumption function. It is
believed that the beneficiaries of windfall gains increase their consumption above the
normal level.

6. Liquid Assets

Changes in liquid assets of people affect their consumption with an increase in their
liquid assets, the people have a tendency to increase their consumption.

1. Financial Policies of Corporations

If corporations and companies retain more reserves and distribute lesser profits in the
form of dividends, the disposable incomes of the share holders will be smaller.
In contrast if more profits are distributed more will be spent on consumption.

2. Change in Expectations

If the consumers expect a shortage or rise in prices of certain goods they may rush to
purchase such goods in excess of their current needs. This would raise the consumption

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function. On the other hand, if the people expect a decline in price they would tend to
postpone purchases of such goods which would lower the consumption function.

The consumption of a person is also influenced by expectation as to what his income

will be in the future. If he expects an increases in income in future he will tend to
consume more.

3. Windfall Gains or Losses

Sudden and unexpected gains and losses in income affect consumption function. It is
believed that the beneficiaries of windfall gains increase their consumption above the
normal level.

4. Liquid Assets

Changes in liquid assets of people affect their consumption with an increase in their
liquid assets, the people have a tendency to increase their consumption.

5. Selling Effort

Given the level of income an increase in selling effort may increase the total volume of
consumer’s expenditure. But this factor has not been given much attention in the
theory of aggregate demand.

6. Relative prices

There is a tendency among economists to ignore the effect of changes in relative prices
on the aggregate demand. But infact changes in relative prices can affect aggregate
consumer demand.

7. Volume of Wealth

The larger the wealth possessed by a person, the lower would be its marginal utility to
him and as such the weaker would be the desire to add to future wealth by reducing
current consumption.

8. Demographic Factors

Even at a given level of income the consumption expenditure may differ from family to
family. Such differences consumption can be explained by demographic factors which
include size of the family, place of residence, occupation. Other things remaining
unchanged the large sized families would spend more. Families with children of
college

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age would spend more than those with children of primary school age further the urban
families have tendency to spend more than the rural families.

9. Terms of Consumer Credit

The terms of consumer credit exert an important influence on consumer purchases of

durables. In recent years there has been considerable increase in the volume of
purchases of consumer durables financed by consumer credit. It is generally recognized
that the interest rate paid on installment credit is not of so much importance.

10. Permanent Income

A family’s expenditure on consumption is determined not by its current income but by

its permanent income.

11. Consumer Durables

The short run instability of consumption expenditure in relation to income is

considerably concentrated in the area of consumer durables. The logic of the
consumption function suggests that it is the current services rendered by durable goods
which are desired in an amount related to current income. The purchase of durables are
considerably influenced by the size of the existing stock of durable goods possessed by
the consumers.

Subjective Factors

Keynes mentions the following important motives of a subjective nature which lead
people to refrain from spending.

1. To build up reserve against unforeseen circumstances.

2. To provide for an anticipated future relation between income and the needs of
the individual different from that which exists in the present.
3. A larger real consumption at a later date is preferred to a smaller immediate
consumption.
4. To enjoy a gradually increasing expenditure.

5. To enjoy a sense of independence and the power to do things.

6. To carry out speculative projects.

7. To bequeath a fortune.

8. To satisfy a pure miserliness.

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 The above motives are called by Keynes as the motives of precaution, foresight,
calculation, improvement, independence, enterprises, pride and avarice and the
corresponding motives to consumption are called enjoyment, short sightedness,
generosity, miscalculation, ostentation, and extravagance.

In addition, Keynes gave the motives of enterprise, liquidity improvement and

financial precedence whereby firms and corporations save, thus reducing consumption
expenditure. But these psychological characteristic of human nature do not undergo
much change in a short period. Therefore Dillard concluded that although the
propensity to consumer is stable in the short period it is not absolutely rigid. Subjective
factors can bring shifts in consumption function effectively.

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 Fig. 11.B

9.4. Summary

The text expressed the consumption demand depends upon the

level of income and the propensity to consume. Consumption function
or propensity to consume means the whole of the expenditure at various
levels of income. It means how consumption expenditure increases as
income increases. The consumption function or propensity to consume,
therefore, indicates a functional relationship between two aggregates,
viz., total consumption expenditure and the gross national income. It is
a schedule that expresses relationship between consumption and
disposable income.

In text questions

1. Define propensity to consume.

2. Explain average and marginal propensity to consume.

3. Identify factors affecting

consumption function. Key Words

Propensity to consume, average propensity to consume,

marginal propensity to consume and consumption function.

Saving Function:
Saving is defined as the part of income which is not consumed. This is
because disposable income is either consumed or saved.
Thus
Yd = C + S
S=Y–C
where Yd = Disposable income, C = Consumption, S = Saving
Saving is a function of income. Thus, saving function can be written as
S= f(Y)

Let us take the Keynesian consumption, C = a + bY.

We can derive saving function corresponding to it. Since Y = C + S
S=Y–C
Now, substituting the above Keynesian function for C in (i) we have
S = Y – (a + bY)
= Y – a – bY
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= – a + Y – bY
= – a + (1 – b) Y

Note that (1 – b) in the above saving function is the value of marginal

propensity to save(MPS) where b is marginal propensity to consume(MPC).

Let us give a numerical example. Suppose the following consumption

function is given.
C = 150 + 0.80 Y S = Y – C
Substituting the given consumption function for C we have
S = Y – 150 – 0.80 Y
= – 150 + Y – 0.80 Y
= 150 + (1 – 0.80) Y
= – 150 + 0.20 Y
MPS= .20

Important : The sum of marginal propensity to consume and marginal

propensity to save is equal to one
(MPC + MPS = 1).

Now let us look at the difference between average propensity to save and
marginal propensity to save-

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Average propensity to save:
Average propensity to save is the proportion of disposable income that is
saved (i.e. not consumed).

Mathematically
APS = Savings/Disposable Income = S/Y

Like the average propensity to consume (APC) average propensity to save

also changes as income increases.
According to keynes average propensity to consume (APC) falls as income
increases. This implies that average propensity to save (APS) will increase
as income rises.
Income is either consumed or saved:
C+S=Y
Dividing both sides by disposable income Y we have C/Y + S/Y + Y/Y = 1
Since C/Y is average propensity to consume and S/Y is average propensity
to save, we have
APC + APS = 1
This implies APS = 1 – APC
If APC = 0.75, then economy will save 25 per cent of its disposable income
or its average propensity to save (APS) will be 0.25
(1 – 0.75 = 0.25).

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In Fig. 6.6 we show the savings curve. The saving curve SS shows the gap
between consumption curve CC and the income curve OZ in the upper
panel of Fig. 6.6. It will be seen that up to income level OY1 consumption
is more than income, that is, there is dissaving.
Beyond income level OY1, there is positive saving. As average propensity
to consume (APC) falls with the increase in income in the upper panel,
Average propensity to save rises as income increases.
Thus in Fig. 6.6 with the increase in income not only
the absolute amount of saving increases, the average propensity to save also
increases.

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Marginal Propensity to Save (MPS):
Marginal propensity to save represents how much of the additional
disposable income is devoted to saving. The marginal propensity to save is
therefore change in savings induced by a change in the disposable income.
Thus,
MPS = ΔS/ΔY

For example, if disposable income increases from rupees 10,000 to 12,000

and this causes planned savings to increase by Rs. 500 crores, marginal
propensity to save is:
MPS = 500/2000 = 1/4 = 0.25

Since the additional income is either consumed or saved, the sum of

marginal propensity to consume and marginal propensity to save is equal to
one.
MPC + MPS = 1
We can prove this mathematically -
From C + S = Y, it follows that any change in income must induce either
change in consumption or change in saving . Thus.
ΔC + ΔS = ΔY
Dividing both sides by ΔY we have ΔC/ΔY + ΔS/ΔY = ΔY/ΔY = 1 MPC +
MPS = 1

The concept of marginal propensity to save is graphically shown at the

bottom of Fig. 6.6. According to the figure when disposable income
increases from OY1 (say Rs. 10,000) to OY2 (say Rs. 12,000), that is, ∆Y
= Rs. 2000, the saving increases by Y2T, (Rs. 500), that is, ΔS is Rs. 500.
Thus marginal propensity to save (MPS) is

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ΔS/ΔY = Y2T/Y1Y2 = 500/2000 = 1/4 = 0.25

Determinants of Propensity to Consume: The important question is on what

factors the propensity to consume of a community depends. In
other words, what are the factors that determine the level and position of the
propensity to consume or the consumption function? Keynes divided the
factors determining the propensity to consume into two groups: the first
group of factors was called by him as subjective factors and the second
group was named by him as objective factors. We shall explain below in
detail these subjective and objective factors which affect the consumption
function of a community.

Important Features of Keynes’ Consumption Function:

In macroeconomics, Keynes’s consumption function plays a highly
important role. Therefore, it is essential to state its important features.

The following are the important features of Keynes’s consumption

function:
First, absolute level of current income is the important factor that
determines consumption of the

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community. Increase in national income causes an increase in consumption.
On the other hand, classical economists thought that it was rate of interest
that primarily determined saving and consumption of the community. A rise
in rate of interest induces the people to save more and thus to reduce their
level of con- sumption.
According to Keynes, though rate of interest is one of the factors that
determine consumption of the community, he did not consider it a very
important determinant of it. By considering level of current income as the
most important factor determining consumption and saving, Keynes made a
significant contribution to the macroeconomic theory.
The second important feature of Keynes’ consumption function is that
marginal propensity to consume is less than one but greater than zero (0 <
MPC < 1). As has been explained above, the feature of Keynes’s
consumption function that marginal propensity to consume is less than one
is known as Keynes’s psychological law of consumption. According to this
law, as income increases, consumption increases but not as much as the
increase in income.Keynes’s theory of multiplier is based on the marginal
propensity to consume being less than one but greater than zero.

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Additional Information:
How Consumption and Savings Drive Economic Growth
At its core, an economy's health and vibrancy can largely be gauged by
examining its consumption behaviour and savings patterns. Consumption
and savings are like two sides of the economic coin and they
simultaneously drive economic growth through distinct mechanisms.
If households exhibit high consumption expenditure, this prompts
businesses to ramp up production to meet growing demand, in turn,
stimulating the economy. However, this consumption is only sustainable in
the long run if it is buoyed by adequate savings too.
Although higher saving rates can result in a slowdown in economic growth
in the short term through reduced consumption, it is these accumulated
savings that provide the necessary capital for investment, which ultimately
leads to economic expansion in the longer term.
Consumption as a significant component of GDP
In macroeconomics, consumption is often considered the most significant
component of a nation's Gross Domestic Product (GDP). GDP, representing
the total value of goods and services produced in an economy, is comprised
of four key elements - Consumption, Investment, Government Expenditure
and Net Exports. Among these, consumption constitutes a major part.
The consumption spending of households on both durable (like cars,
furniture) and non-durable goods (food, clothing), as well as services
(medical care, education) are all aggregated into GDP. Therefore, higher
levels of consumption expenditure indicate a healthier, more robust
economy.

Autonomous consumption refers to the level of consumption expenditure

that occurs when income is zero. It's the consumption that would still occur
even if a consumer had no income. This could, for instance, be funded by
past savings.
The Marginal Propensity to Consume, (MPC) represents the proportion of
additional income that a consumer spends on consumption. If, for example,
for every extra pound earned, 60p is spent on consumption, then the MPC
equals 0.6.

An understanding of the Consumption Function highlights the economic

decision-making process of consumers and serves to predict future patterns
of consumption behaviours.
Key Components of the Consumption Function
The Consumption Function possesses two essential elements. They are the
autonomous consumption and the induced
18 consumption.
Autonomous Consumption: This refers to the minimum level of spending
needed for basic life sustenance. It is not influenced by current income and
typically includes expenses on essentials such as food and shelter.
Induced Consumption: Induced consumption varies directly with the level
of income. In other words, as income levels rise, so does induced
consumption.

The Marginal Propensity to Save (MPS) is the fraction of each additional

pound of disposable income that is saved. For instance, if the MPS is 0.3,
this means that for every extra pound of income, 30p is saved.
The Savings Function is fundamental to understanding how households
decide to split their income between consumption and savings. This
knowledge sharpens the fiscal policy tools economists and policymakers
use to manage fluctuations in the economy.
Savings Function and its Implications on the Economy
To underline the critical role savings play in an economy, one must
consider two essential perspectives: microeconomic and macroeconomic.
At a microeconomic level, a higher saving rate exemplifies individual or
household financial stability. It enables planning for the future, and often,
these savings form the backbone of a country's investment capital.
From the macroeconomic perspective, national savings form an essential
pillar of the country's economic growth strategy. Savings provide a
significant reservoir of funds, which are then available for investments in
productive assets, driving economic growth. Therefore, economists and
policymakers study the savings function to comprehend and forecast
investment and economic growth trends. Knowledge of savings patterns can
also help manage economic fluctuations and challenges like inflation and
unemployment.
In conclusion, understanding the Consumption and Savings functions
serves as a valuable tool in the policymaker's macroeconomic toolkit,
enabling them to influence national economy.

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In Keynes consumption function, namely, C = a + by, as income increases,
average propensity to consume (APC) falls. Keynes was of the view that
rich people relatively save a higher proportion of their income so that at
higher levels of income average propensity to consume (APC), that is,
proportion of total consumption to national income falls as national income
rises.
Another important feature of consumption function as put forward by
Keynes is that it remains stable in the short run. Consumption function,
according to Keynes, depends on various institutional factors such as
distribution of income and wealth and psychological factors such as
willingness to save.
Since there cannot be much changes in these institutional and psychological
factors, consumption function remains stable in the short run, that is, it does
not shift upward or downward. Therefore, Keynes in his theory explains the
determination of income and employment in the short run by considering
that the consumption function is stable.

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