Consumption Function

Consumption 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. 1
 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. 2
 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. 3
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.
4
 Propensity to Consume: A Schedule
(Rs. In Crores)

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

100 120 -20

200 200 00
300 280 20
400 360 40
500 400 100

5
 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: 6
 Y Y=C

consumption

S2

C
S1
C2

C1 B S

S3

s4
O
Y1 Y2 X

S Income
7
 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. 8
 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.
9
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:

10
 Y

Consumption (Rs.)

C
90
B
80
A
C

X
O 100 120

Income (Rs.)

11
 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.
12
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:
13
 MPC = C/ Y
Where, 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. 14
 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

Consumption (Rs.)
C
90 B
C A MPC
80

C
Y
X
O 100 120

Income (Rs.) 15
 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.
16
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:

Fig: a Y Fig: b
Y
C’
C3
C C
C1
C C2

Y Y1 O Y
O X X 17
 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: 18
(i) Motive of Precaution:
Precaution Which encourages savings to
meet unforeseen emergencies in future.
(ii) Motive of Foresight:
Foresight Reserves are built to cover
anticipated future needs such as old age.
(iii) Motive of Calculation:
Calculation the desire to enjoy interest.
(iv) Motive of improvement:
improvement the desire to enjoy the
gradually increasing income.
(v) Motive of Independence:
Independence The desire enjoy a sense
of independence.
(vi) Motive of enterprise:
enterprise the desire to establish a
business project.
(vii) Motive of pride:
pride the desire to posses and bequeath
wealth.
(viii)Motive of avarice:
avarice the desire to satisfy miserliness.19
(b) There are certain factors which encourage
consumption such as:
Generosity, short-sightedness, enjoyment,
miscalculation, extravagance etc. etc
(c) There are certain factors which encourages
savings in corporate sectors, such as
(i) Motive of Enterprise:
Enterprise the desire to acquire
resources to carry out further investment.
(ii) Motive of Liquidity:
Liquidity The desire to cope up with
emergencies successfully.
(iii) Motive of Financial Prudence:
Prudence to make
sufficient financial provision against depreciation.
 This shows the psychological and institutional
factors determines the decisions whether to
consume or save. 20
Objective Factors in the Consumption Function:
Function
There are some important factors which causes
shift in the consumption function in the community.
These are as follows:

(a) 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: Imposition of heavy taxation, diversion of
resources during Second World War have
depressed the consumption function below its
normal condition.
21
(b) 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) 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. 22
(d) Windfall gains or losses: The rapid changes in the
capital value which occur in the stock market, may
increase consumption function.
Example: Recent boom in the stock market has increased
the consumption in the hands of people.
(e) Changes in Price Level:
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) Distribution of Income:
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. 23
(g) Duesenberry Factors:
Factors Prof. Duesenberry has
given two important factors affecting the
consumption function, as:
(i) Past standard of Living:
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) Demonstration Effect:
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. 24