Propensity to consume
is also called consumption function. In
the Keynesian theory, we are concerned not with the consumption of an individual
consumer but with the sum total of consumption spending by all the individuals.
However, in generalizing the consumption behaviour of the whole economy,
we have to draw some useful conclusions from the study of the behaviour of a
normal consumer, which may be valid for all consumers’ behaviour of the
economy. Aggregate consumption
depends on consumption function or propensity to consume.
The economic term ‘consumption’
means the amount spent on consumption at a given level of income.
‘Consumption function’ or ‘propensity to consume’
means the whole of the schedule showing consumption expenditure at various
levels of income. It tells us how
consumption expenditure increases as income increases.
The consumption function or propensity to consume, therefore, indicates a
functional relationship between the aggregates, viz., total consumption
expenditure and the gross national income.
It is a schedule that expresses relationship between consumption and
Keynesian theory, following are the factors that influence consumption:
(a) The real income of the individual,
(b) The past savings, and
Rate of interest.
and Marginal Propensities to Consume:
propensity to consume (apc) is a relationship between total consumption and
total income in a given period of time. In
other words, apc is the ratio of consumption to income.
Where C : Consumption
Y : Income
Average propensity to consume
While, the marginal
propensity to consume (mpc) measures the incremental change in consumption as a
result of a given increment in income. In
other words, mpc is the ratio of change in consumption to the change in income.
Where ΔC : Incremental change in consumption
ΔY : Incremental change in income
Marginal propensity to consume
relationship between income and consumption is that when income increases,
consumption also increases, but by less than the increase in income.
In other words, in normal circumstances, mpc is less than one.
It is drawn as a straight-line with a slope of less than one.
This slope indicates the percentage of additional disposable income that
will be spent. It is assumed that
the whole additional income is not spent, i.e., a certain amount is spent and
the remainder is saved. This can be
further explained with the help of following table and diagram:
In the above diagram, OL is the income line and OP is income consumption curve. The income consumption line OP lies below the income line OL. The mpc will be measured by the tangent of the angle that income consumption curve makes with X-axis.
The curve as we have
drawn turns out to be straight line rising from the origin, which means that mpc
is constant throughout. This,
however, need not be so and the curve may well become flatter as income rises,
for as more and more consumption needs have been satisfied, a greater share of
an increase in income than before may be saved.
The dotted curve OM represents such a relationship showing that as income
rises, mpc becomes smaller and smaller.
There is a level of
disposable income (DI) at which the entire income is spent and nothing is saved.
This point is often known as ‘point of zero savings’.
Below this level of DI, the consumption expenditure will exceed the DI. There may be cases in which the consumer has no income at
all. In such cases, the income
consumption curve may not rise from the origin but from farther left showing
that when income is zero, consumption is not zero and that the individual is
living on his past savings.
In the above diagram, ON represents the saving-income curve. Savings at a given level of income can also be read off from the distance between a point on income-consumption curve and corresponding point on income curve (See the figure of income-consumption relationship). The marginal propensity to save (mps) can be measured by the slope of income-saving curve ON. Marginal propensity to save (mps) is the increment in savings caused by a given increment in income. The mps is always equal to one minus mpc:
Law of Consumption:
Keynes propounded a
law based on the analysis of consumption function.
This law is known as ‘Fundamental Law of Consumption’ or ‘Psychological
Law of Consumption’. It
states that aggregate consumption is a function of aggregate disposable income.
of the Law:
This law consists of
When aggregate income increases, consumption expenditure will also
increase but by a somewhat smaller amount.
When income increases, the increment of income will be divided in same
proportion between saving and consumption. Consumption and saving go side by side. What is not consumed is saved.
Savings is, thus, the complement of consumption.
As income increases, both consumption spending and saving go up.
An increment in income is unlikely to lead either to less spending or
less savings than before. It will
seldom happen that a person may decrease his consumption or his savings when he
has got more income.
Habits of people regarding spending do
not change or that the propensity to consume remains the same or stable.
The economic conditions remain normal.
There is no hyper-inflation or war or other abnormal conditions.
is a free-market economy. There
is no government intervention.
characteristic of the slope of consumption function is that the marginal
propensity to consume (mpc) will be less than unity.
This results in low-consumption and high-saving economy.
According to Keynesian theory, the mpc is less than unity, which brings out the following implications:
consumption largely depends on income and consumption function is more or
less stable, it is necessary to increase investment fill the gap of
declining consumption as income increases.
If this is not done, the increased output will not be profitable.
income increases, and the consumption are not increased, there is a danger
of over-production. The government will have to step in to remedy the situation.
Therefore, the policy of laissez-faire will not work here.
If the consumption is not increased, the marginal efficiency of capital (MEC)
The demand for capital will also diminish, and all the economic progress
will come to a standstill.
explains the turning points in the business cycle.
When the trade cycle has reached the highest point of prosperity, income
has gone up. But since consumption
does not correspondingly go up, the downward cycle starts, for demand has lagged
behind. In the same manner, when
the business cycle has touched the lowest point, the cycle starts upwards,
because consumption cannot be diminished beyond a certain point.
This is due to the stability of mpc.
Since the mpc
is less than unity, this law explains the over-saving gap.
As income goes on increasing, consumption does not increase as much. Hence saving process proceeds cumulatively and there arises a
danger of over-saving.
This law also
explains the unique nature of income generation.
If money is injected into the economic system, it will increase
consumption but to a smaller extent than increase in income.
This again is due to the fact that consumption does not increase along
with increase in income.
Influencing Consumption Function:
There are certain
factors affecting the propensity to consume in the long-run:
of income: It is generally observed
that the average and marginal propensities to consume of the poor are greater
than those of the rich. This is
because the poor has a lot of unsatisfied wants and he is likely to seize every
opportunity that comes his way to satisfy them.
On the other hand, the rich have already a high standard of living and
relatively less urgent wants remain to be satisfied, so that in their case, an
addition to their incomes is more likely to be saved than spent on consumption.
policy: Fiscal policy of the government
will also influence the consumption behaviour of an economy.
A reduction in taxation will leave more post-tax incomes with the people
and this will stimulate higher expenditure on consumptions.
Similarly, an increase in taxes will depress consumption.
in business expectations:
Business expectations by affecting the incomes of certain classes of
people affect consumption function.
gains and losses:
The windfall losses and gains arising out of changes in capital values
affect the ‘saving brackets’ mostly and not the spending sections.
Hence, their influence on consumption function is not so well marked.
factor is the people’s liquidity preferences.
If people prefer to keep their income in liquid ford, consumption is
Substantial changes in the rate
motives to save:
Building of reserves for unforeseen contingencies as illness or
To provide for anticipated future needs such as daughter’s wedding,
son’s education, etc.
To enjoy an enlarged future income by investing funds out of current
The desire to expand business,
The desire to face emergencies successfully,
The desire to have successful management,
The desire to ensure sufficient financial provision against depreciation
for Raising Consumption:
Redistribution of income in favour of poor where propensity to consume is
Comprehensive social security measures like unemployment doles, old-age
pension, sickness insurance, etc.
Liberal wage policy, and
Credit facilities for middle and poor classes for purchasing more
of Consumption Function:
Important tool of macro-economic analysis.
Value of the multiplier gives us a link between changes in investment and
changes in income.
Consumption function invalidates the Say’s Law, which states that
supply creates its own demand, because this theory does not hold accurate in the
It shows the crucial importance of investment.
It explains the reasons of declining MEC.
It explains the turning points of business cycle.
Developments Regarding Consumption Function:
The Ratchet Effect:
Professor Duesenberry says that in matter of consumption, an individual
is not merely influenced by current income, but also by standard of living in
The consumers are not easily reconciled to fall in their income.
They try hard to maintain their previous standard of living.
This is to maintain their position among their relatives, friends and
Consumption as a
proportion of income goes up as income increases and does not fall in the same
proportion as the income falls. In
other words, consumption is not reversible.
This is known as ‘Ratchet Effect’.
The Duesenberry Hypothesis suggests that the consumer expenditure depends
on relative and not on absolute incomes. The
consumption function is linear rather than curved because it is the income of a
family relative to that of other families.
The ‘Demonstration Effect’ determines how much a consumer
spent and how much he saves. Middle-class
and poor people imitate the life style of rich people.
People in under-developed countries try to follow the consumption pattern
of affluent nations. This is called
the ‘Demonstration Effect’, and it is dangerous as it retards the economic
When prices fall as a result of a cut in
money wages, the purchasing power of money with a consumer increases, or there
is an increase in the real value of money. People feel that they are now better off and they increase
their consumption expenditure. This
leads to expansion in GNP and has been referred to as ‘Pigou Effect’.
Keynes seems to be agreed that theoretically it is possible to bring
about full employment by sufficiently lowering the money wages.
But the process would be so slow that it could be ignored as a practical
possibility. It would be more
realistic to assume that wages are not so flexible (as assumed by Pigou) as to
permit the working of Pigou effect to bring about full employment.
Another factor which affects consumption and the level of economic
activity is the government expenditure.
It differs from country to country and in the same country it differs
Government may have a vital role in creating employment, influencing
consumption and adjusting saving through fiscal and other policies.
of Consumption Function:
There are three
different economic theories explaining consumption-income relationship:
Income Theory: According
to Keynes, on average, men increase their consumption as their income increases
but not by as much as the increase in income.
In other words, the average propensity to consume goes down as the
absolute level of income goes up. Hence,
according to this theory, the level of consumption expenditure depends upon the
absolute level of income and the relationship between the two variables is
non-proportionate. However, it is
pointed out that although this relationship is one of non-proportionality, yet
there is illusion of proportionality caused by factors other than income, viz.,
accumulated wealth, migration to urban areas, new consumer goods, etc.
Owing to such factors as these, the consumers spend more and the
relationship appears to be proportional.
The Relative Income Hypothesis was first introduced by Dorothy Brady and
Ross Friedman. It states that the
consumption expenditure does not depend on the absolute level of income but
instead the relative level of income.
to Dussenberry, there is a strong tendency for the people to emulate and imitate
the consumption pattern of their neighbours.
This is the ‘demonstration effect’.
The relative income hypothesis also tells us that the level of
consumption spending is determined by the households’ level of current income
relative to the highest level of income earned previously.
People are then reluctant to revert to the previous low level of
consumption. This is ‘ratchet
relative income theory states that if current and peak incomes grow together
changes in consumption are always proportional to change in income.
That is, when the current income rises proportionally with peak income,
the apc remains constant.
This proportionality relationship can be illustrated by the following diagram:
and consumption lines (Y and C) show proportional relationship, when income
grows steadily. Similarly, if
income grows in spurts and dips, the response of the consumption is same.
Thus Y’ and C’ lines show proportional relationship.
Income Hypothesis: Friedman draws a
distinction between permanent consumption and transitory consumption.
Permanent consumption stands for that part of consumer expenditure which
the consumer regards as permanent and the rest is transitory.
Distinction can also be made between durable and non-durable consumer
goods. Durable consumption is
concerned with purchasing capital assets and in the case of non-durable goods
the act of consumption destroys the good. Ordinary
consumer expenditure relates to non-durable consumption, i.e., consumption of
goods which are quickly used in consumption.
These are the ‘flow’ items since a flow of them is being
continuously consumed. On the other
hand, durable consumption, which relates to the purchase of capital assets, is
an act of investment. These are ‘stock’
to Friedman, permanent consumption (Cp) is a function of:
(i) Rate of interest,
(ii) Rates of consumer’s income from property and his personal effort, i.e., human and non-human wealth, and
Consumer’s preference for immediate consumption multiplied by permanent
permanent income theory really emphasises the important role of capital assets
or wealth in determining the size of consumption.
It shows how both income and consumption are closely linked with the
consumer’s wealth. It is capital
and wealth, which affects the level of consumption rather than consumer’s
Cycle Hypothesis: According
to Life Cycle Hypothesis, the consumption function is affected more by
consumer’s whole life income rather than his current income.
This view has been put forward by Modigliani, Brumberg and Ando.
The permanent income hypothesis focuses attention on the income of the
consumer earned in recent past as well as expected future earnings (and wealth).
But the life cycle hypothesis states the consumption function depends
upon consumer’s whole life income. In
childhood, the consumer earns nothing but spends all the same (his parents spend
on him); in the middle age, when he comes to have a family, he earns and spends.
But he will be earning more than he spends.
He tries to save enough to maintain himself in his old age when he will
not be able to earn or earn much. Over
his life span, the consumer tries to maintain a certain uniform standard and
with that end in view he organises whole life’s uneven income flows of cash
receipts. In other words, he will arrange his income and expenditure in
such a manner as to maintain a certain standard of living which he desires.
The ‘Life Cycle Hypothesis’ seems to be quite realistic and plausible. It may be noted, however, that this hypothesis emphasises income as derived from wealth more than cash receipts. It also draws our attention to the fact that the consumers have to make a choice between immediate consumption and accumulating of assets for future use.