Saturday, June 5, 2010

Consumption Function

The consumption function or propensity to consume 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,

C = Consumption

Y = Income

f = Functional Relationship.

Thus the consumption function indicates a functional relationship between C and Y, where C is the dependent and Y is independent variable, i.e., C is determined by Y. In fact, consumption function or propensity to consume is a schedule of the various amounts of consumption expenditure corresponding to different levels of income.

Assumption of Consumption Function

1. It is assumed that habit of the people regarding spending does not change or that the propensity to consume remains the same. Normally, the propensity to consume does remain the same; it is more or less stable. This means that we assume that only income changes, whereas the other variables like income distribution, price movements, growth of population, etc. remain more or less constant.

2. The second assumption is that the conditions remain normal; for instance there is no hyperinflation or there is no war or other abnormal conditions.

3. In an economy, where the government interferes with consumption or productive enterprise, the law will not hold good. In that case, the government may check consumption even when income increases. If a country is very poor, the question of choosing between consumption and saving does not really rise. This law can, therefore, apply to a free economy and in peace time and over a short period.

Features of Consumption Function:

1. When income increases, consumption expenditure also increases but by a smaller amount. The reason is that as income increases, our wants are satisfied side by side, so that the need to spend more on consumer goods diminishes. It does not mean that the consumption expenditure falls with the increase in income. In fact, the consumption expenditure increases with increase in income but less than proportionately.

2. The increased income will be divided in some proportion between consumption expenditure and saving. This follows from the above feature because when the whole of increased income is not spent on consumption, the remaining is saved. In this way, consumption and saving move together.

3. Increase in income always leads to an increase in both consumption and saving. This means that increased income is unlikely to lead either to fall in consumption or saving than before. This is based on the above features because as income increases consumption also increases but by a smaller amount than before which leads to an increase in saving. Thus with increased income both consumption and saving increase.


Average Propensity to Consume (APC) and Marginal Propensity to Consume (MPC):

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. It is expressed as the percentage or proportion of income consumed. The APC at various income levels is shown in Table. The APC declines as income increases because the proportion of income spent on consumption decreases.

The marginal propensity to consume may be defined as the ratio of the change in consumption expenditure to the change in income or as the rate of change in the average propensity to consume as income changes. It is found by dividing change in consumption expenditure by a change in income or MPC = ΔC ÷ ΔY. The MPC at various income levels is shown in Table. The MPC declines as income increases because the proportion of income spent on consumption decreases.

Average Propensity to Save (APS) and Marginal Propensity to Save (MPS):

Saving is defined as the part of income which is not consumed because income is either consumed or saved. Thus,

Y = C + S

S = Y – C

Average propensity to save is the proportion of income that is saved (not consumed). Mathematically, APS = S + Y. Average propensity to consume falls as income increases. This implies that average propensity to save will increase as income rises. The APS at various income levels is shown in Table.

There is an important relationship between average propensity to consume and average propensity to save. We know,

C + S = Y

Dividing both sides by income Y, we get,

C ÷ Y + S ÷ Y = Y ÷ Y

APC + APS = 1

Marginal propensity to save may be defined as the ratio of the change in savings to the change in income or as the rate of change in the average propensity to save as income changes. It is found by dividing change in saving by a change in income or MPS = ΔS ÷ ΔY. The MPS at various income levels is shown in Table. The MPS increases as income increases because the proportion of income saving increases.

There is an important relationship between marginal propensity to consume and marginal propensity to save. We know, C + S = Y, it follows that any change in income (ΔY) must induce either change in consumption (ΔC) or change in saving (ΔS). Thus,

ΔC + ΔS = ΔY

Dividing both sides by ΔY, we get,

ΔC ÷ ΔY + ΔS ÷ ΔY = ΔY ÷ ΔY

MPC + MPS = 1

Relationship between APC and MPC:

1. If income increases both APC and MPC decreases but APC decreases at slower rate than MPC. (Table)

2. If income decreases both APC and MPC increases but APC increases at slower rate than MPC. (Table)

3. When APC is constant, at that point both APC and MPC are equal. (Table)

Table: Income, Consumption and Saving

Income

(Y)

Consumption

(C)

Saving

(S)

APC(C÷Y)

MPC(ΔC÷ΔY)

APS(S÷Y)

MPS(ΔS÷ΔY)

1000

950

50

0.950

-

0.050

-

1100

1040

60

0.945

0.900

0.055

0.10

1200

1120

80

0.933

0.800

0.067

0.20

1300

1190

110

0.915

0.700

0.085

0.30

1400

1250

150

0.893

0.600

0.107

0.40

1500

1300

200

0.866

0.500

0.134

0.50

Factors Influencing the Consumption (or) Determinants of Propensity to Consume:

Objective Factors:

1. Distribution of income

It will be generally observed that the average and marginal propensity to consume of the poor people are greater than those of the rich. If, for example, additional $500 is given to poor and rich people, the assumption is that of this additional income, poor people will spend a greater proportion than rich people. This is because the poor man 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. Consumption is typically the function of the poor and saving typically the function of rich.

2. Fiscal policy

Fiscal policy of the government will also influence the consumption behavior of an economy. A reduction in taxation will have more post-tax incomes with the people and this will stimulate higher expenditure on consumption; an increase in taxes will depress consumption. Of the two types of taxes, that is direct and indirect taxes, the latter will have more immediate effect on consumption than the former, particularly when direct taxes are progressive in nature. Commodity taxes penalize consumer expenditure directly by raising the prices of the commodities while taxes on income reduce consumption only indirectly by reducing the post-tax income of the individual.

3. Rate of interest

Rate of interest also affects the propensity to consume and save. It is generally believed that higher rate of interest includes the people to save more and this results in reducing their propensity to consume. But this is not true in case of all the people. Some individuals are of such a type who wants a certain fixed income in the future. And when the rate of interest raises these individuals consume more and save less because with higher rate of interest they can obtain the given fixed income with lesser savings. Therefore, when the rate of interest raises such individuals save less than before. Thus, it cannot be said with certainty whether with the changes in the rate of interest the propensity to consume of the whole community will change or not.

4. Wind fall gains and losses

Windfall gains and losses also affect the propensity to consume. When the prices of the shares go up, the shareholders begin to think themselves better off and this raises their consumption. On the other hand, when the prices of the shares go down, the shareholders have to suffer sudden losses and they begin to think themselves relatively poorer than before. This induces them to reduce their consumption.

5. Change in expectation

Changes in the expectations of the people also influence the propensity to consume. When people expect that war will break out in near future and they expect prices to go up, then they will try to spend more on goods so as to meet the needs of the immediate future. This raises the consumption function in the current period. On the other hand, when people expect the prices to fall they reduce their current consumption so that they should spend more when the prices actually fall.

Subjective Factors:

Individual Motives

· Building of reserves for unforeseen contingencies as illness or unemployment.

· The desire to provide for anticipated future needs such as daughter’s marriage and son’s education.

· The desire to enjoy an enlarged future income by investing funds out of current income.

· The desire to bequeath a fortune to one’s heirs.

· The enjoyment of a sense of independence.

· The enjoyment of power to do things and to hold one’s head high in the society.

· For some people the satisfaction of pure miserliness.

Business Corporation Motives

· The desire to expend one’s business.

· The desire to face emergencies successfully.

· The desire to demonstrate successful management.

· The desire to ensure sufficient financial provisions against depreciation and obsolescence.

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