Saturday, 6 July 2013

Consumption Function: Meaning, determinants and importance.

Consumption, in economics, the use of goods and services by households. Consumption is distinct from consumption expenditure, which is the purchase of goods and services for use by households. Consumption differs from consumption expenditure primarily because durable goods, such as automobiles, generate an expenditure mainly in the period when they are purchased, but they generate “consumption services” (for example, an automobile provides transportation services) until they are replaced or scrapped.

CONSUMPTION FUNCTION:
A mathematical relation between consumption and income by the household sector. The consumption function can be stated as an equation, usually a simple linear equation, or as a diagram designated as the consumption line. This function captures the consumption-income relation that forms one of the key building blocks for Keynesian economics. The two key parameters of the consumption function are the intercept term, which indicates autonomous consumption, and the slope, which is the marginal propensity to consume and indicates induced consumption. Aggregate expenditures used in Keynesian economics are derived by adding investment, government purchases, and net exports to the consumption function.
The consumption function is the starting point in the Keynesian economics analysis of equilibrium output determination. It captures the fundamental psychological law put forth by John Maynard Keynes that consumption expenditures by the household sector depend on income and than only a portion of additional income is used for consumption.This function is presented either as a mathematical equation, most often as a simple linear equation, or as the graphical consumption line. In either form, consumption is measured by consumption expenditures and income is measured as disposable income, national income, or occasionally gross domestic product.
The primary purpose of the consumption function the basic consumption-income relation for the household sector, which is the foundation of the aggregate expenditures line used in Keynesian economics.
The consumption function makes it easy to divide consumption into two basic types. Autonomous consumption is the intercept term. Induced consumption is the slope. Of no small importance, the slope of the consumption function is also the marginal propensity to consume (MPC).

First, The Equation

The consumption function can represented in a general form as:
C=f(Y)
where: C is consumption expenditures, Y is income (national or disposable), and f is the notation for a generic, unspecified functional form.Depending on the analysis, the actual functional form of the equation can be linear, with a constant slope, or curvilinear, with a changing slope. The most common form is linear, such as the one presented here:
C=a+bY
where: C is consumption expenditures, Y is income (national or disposable), a is the intercept, and b is the slope.The two key parameters that characterize the consumption function are slope and intercept.
  • Slope: The slope of the consumption function (b) measures the change in consumption resulting from a change in income. If income changes by $1, then consumption changes by $b. This slope is generally assumed and empirically documented to be greater than zero, but less than one (0 < b < 1). It is conceptually identified as induced consumption and the marginal propensity to consume (MPC).

  • Intercept: The intercept of the consumption function (a) measures the amount of consumption undertaken if income is zero. If income is zero, then consumption is $a. The intercept is generally assumed and empirically documented to be positive (0 < a). It is conceptually identified as autonomous consumption.

Then, The Graph

Consumption Line
Consumption Line

The consumption function is also commonly presented as a diagram or consumption line, such as the one presented in the exhibit to the right. This red line, labeled C in the exhibit is positively sloped, indicating that greater levels of income generate greater consumption expenditures by the household sector. The specific consumption function illustrated in this exhibit is:
C=1+0.75Y
For reference, a black 45-degree line is also presented in this exhibit. Because this line has a slope of one, it indicates the relative slope of the consumption line.
The two primary characteristics of the consumption function--slope and intercept--also can be identified with the consumption line.
  • Slope: The slope of the consumption line presented here is positive, but less than one. In this case the slope is equal to 0.75. Click the [Slope] button to highlight.

  • Intercept: The consumption line intersects the vertical axis at a positive value of $1 trillion. Click the [Intercept] button to highlight.

And Other Factors

The consumption function captures the relation between consumption and income. However, income is not the only factor influencing consumption.
C=f(Y, OF)
where: C is consumption expenditures, Y is income (national or disposable), and now OF is specified as other factors affecting consumption. These other factors, officially referred to as consumption expenditures determinants, include a range of influences. Some of the more notable consumption determinants are consumer confidence, interest rates, and wealth.Consumer confidence is the general optimism or pessimism the household sector has about the state of the economy. More optimism means more consumption. Interest rates affect the cost of borrowing the funds used to purchase durable goods. Higher interest rates mean less consumption. Wealth is the financial and physical assets owned by the household sector. More financial wealth means more consumption, while more physical assets mean less consumption.
These determinants cause consumption expenditures to change even though income does not change. Or another way of stating this, determinants cause consumption expenditures to change at every level of income. For a linear consumption function, this change is reflected by a change in the intercept term (a). For a consumption line, the change is seen as an upward or downward shift.

Determinants Of The Consumption Function Or Propensity To Consume

There are a number of factors both subjective and objective which determine the position of consumption function. The factors or causes of shifts in consumption function are as fellows.

(I) Subjective Factors:

(i) Psychological characteristics of human nature:
                                                            The subjective factors affecting propensity to consume are internal to the economic system. The subjective factors include characteristics human nature: The subjective factors affecting propensity to consume are internal to the economic system. The subjective factors include characteristics of human nature, social practices which lead households to refrain or activate to spending out of their incomes. For example, religious belief of the people towards spending, their foresight, attitude towards life, level of education, etc. etc., directly affect propensity to consume or determine the slope and position of the consumptions curve. The subjective factors do not undergo a material change over a short period of time. These remain constant in the short run.

(II) Objective Factors:

The objective factors are external to economic system. They undergo rapid changes and bring market shifts in the consumption function. The main objective factors are as under:
(1)  Level of Real Income. 
                                     Level of real income is the-basic factor which determines community’s propensity to consume. When real income of the community increases, consumption expenditure also increases but by a Smaller amount. The consumption function shifts upward.
(2)  Distribution of Wealth:
                                          If there is unequal distribution of wealth in a country, the consumption function will also be unequal. People with low income group have high propensity to consume and rich people low propensity to consume. An equal distribution of wealth raises the propensity to consume.
(3)  Expectation of Changes in Price.
                                                If people expect that prices are going to rise in near future, they hasten to spend large sum out of a given income in order to get benefit of low prices. That is what actually, happened just after the promulgation of first Martial Law in our country. So we can say that when priCes are expected to be high in future, the propensity to consume increases or the consumption function shifts upward. When they are expected to be low, the propensity to consume decreases or the consumption function shifts downward. .
(4)  Changes in Fiscal Policy: Taxes also play an important part in influencing the propensity to consume. If the nature of taxes is such that they directly affect the poor people and redUce their incomes, then the propensity to consume is high and if rich persons are not taxed at a progressive rate and they accumulate more wealth, then the propensity to consume is low.
(5)  Changes in the Rate of Interest: A change in the rate of interest exercises influence on the propensity to consume. When the interest rate is raised, it generally induces people to decrease expenditure and save more for lending purposes, On the other hand, when the interest rate is reduced, it usually encourages expenditure as lending then becomes less attractive. So we conclude that an increase in the rate of interest generally reduces propensity to consume or shifts ,the consumption function downward and a fall in the rate of interest usually helps to the increase of propensity to. consume or shifts the consumption function upward.
(6), Availability of Goods: 
                                         Propensity to consume is also affected by the availability of consumption goods. If the goods are available in abundance, then the propensity to consume increases. If they are scarce and are priced very high, then the propensity to consume will decline.
(7)  Credit Facilities: If cheap credit facilities are available in the country, the consumption function will move upward.
(8)  Higher Living Standard:
                                If the real income of the people increases in•the country and people adopt the use of new products like television, washing machines, refrigerators, cars, etc., etc., the consumption function is high.
(9)  Stock of Liquid Assets: 
                                    If the consumers have greater amounts of liquid assets, there will be more desire for the households to spend out of disposable income. The consumption function shifts upward and vice versa.
(10)      Consumer Indebtedness:
                                            In case the consumers are heavily indebted and they pay bigger monthly installments to repay the debt, then propensity•to consume is low or the consumption function shifts downward and vice versa.
11) Windfall gains:
                                 If there are unexpected gains due to stock market boom in the economy, it tends to shift the consumption function upward. They are windfall gains.
The unexpected losses in the stock market lead to the downward shifting of the consumption curve.
(12)   Demographic factors:
                                The consumption function is also influenced by demographic factors like size of family, occupation’s, place of residence etc. Persons living in cities, for instance, spend more than those living in rural areas.
(13)   Attitude towards saving: 
                                     If a community is consumption oriented, there will be less • saving in the country. The consumption function shifts upward. In case, people save more and spend less, then the consumption function will shift downward.
(14) Demonstration effect. 
                                     If people are easily influenced by advertisements on radio and television and seeing pattern of living of the rich neighbours, the level of total consumption will go up.
How to raise the propensity to consume: The propensity’ to consume can be raised by (1) transferring •wealth from rich to the poor (2) increased wages (3) provision of cheap end easy credit facilities (4) Advertisements (5) Development of means of transport (6) Urbanization and through advertisement.

Concept Of Propensity To Save Or Saving Function

The propensity to save schedule which for the sake of brevity is called ‘the propensity to save’ shows relation between saving and disposable income at varying levels of incomes S = F(Y). The propensity to save schedule comes from subtracting, consumption • from income at each level of income. Since saving represents the difference ‘between the 450 guideline and the consumption function, it may be positive or negative. The propensity to save schedule can easily be derived:from the propensity to consume schedule, in our example given earlier, the propensity to consume is as follows:-
Income                     Rs. (billion)
50,
100,
140,
•  200
300
Expenditure Rs. (billion)
50,
70,
100,
140,
200
The propensity to save schedule can easily be derived by subtracting the amount of consumption from the corresponding amount of income. The saving schedule thus is as – follows:‑
Income
Rs. (billion)
50,
100,
140,
200
300
Save
Rs. (billion)
0,
30,
40,
60,
100
Concepts of propensity to save.
There are two concepts of propensity to save:
(i) Average propensity to save. (ii) Marginal propensity to save.
(i)  Average propensity to save: Average propensity to save is the percentage of income saved at a given level of income (APS). The average propensity to save at any point can be found by dividing saving by income. For instance, if the disposable income is Rs. 100 billion and expenditure Rs. 80 billion on consumption goods, then the saving win be equal to Rs. 20 billion. The average propensity to save will be = .2. The average propensity to save .can also be found by subtracting average propensity to consume from 1. In the above example, the average propensity to consume is
80  •
- .8. So the average propensity to save will be 1 – .8 = .2
1000
(ii)  Marginal Propensity to save: Marginal propensity to save is the ratio of change in saving to change in income. The MPS measures the change in saving
generated by a change in income.
MPS – Change in saving
Change in income
It is also found out by substracting marginal propensity to consume form I. Thus MPS
= I – MPC. The concepts of propensity to save and marginal propensity to save are
illustrated below:

Importance of the Consumption Function

 Importance of the Consumption function Consumption function is not to be considered merely a subject of study and analysis. It has a great theoretical and practical importance. All countries want to remove unemployment from their midst, raise their national income and enjoy prosperity. For this purpose a policy of planned economic development is essential. In the formulation of this policy, consumption function plays a very useful role.

Consumption function is not to be considered merely a subject of study and analysis. It has a great theoretical and practical importance. All countries want to remove unemployment from their midst, raise their national income and enjoy prosperity. For this purpose a policy of planned economic development is essential. In the formulation of this policy, consumption function plays a very useful role.
We briefly discuss below the importance of
consumption from various points of view:

1. Important Tool of Macro-economic Analysis.
                                                   Consumption function is an important tool of macro-economic analysis given to us by Keynes. Without the consumption function, we would not have been able to find a determinate link between changes in investment and the resultant changes in income of a country. From this point of view, for the macro-economic theory, the consumption function is as important a tool as the demand and supply functions is in the theory of firm and the industry.

2. The Value of the Multiplier.
                                       From the consumption function, we derive the value of the multiplier, which as we have known are equal to1/ 1-mpc. Here MPC is marginal propensity to consume. Since marginal propensity to consume is less than unity, an initial injection of purchasing power into the income stream leads to a multiple expansion of total income in a peculiar way. That is, original' injection of money into the economy leads to several successive increments of income in the course of responding 10 the increase in original purchasing power. The multiplier gives us a quantitative link between changes in investment and changes in income. If, for example, the marginal propensity to consume is f, we know that the multiplier will be 4 so that if investment increases by say, Rs.-1,000, national income will rise by Rs.-4,000. Even before Keynes, the economists knew that changes in investment bring about changes in income but by how much and through which process was not clear, till Keynes gave us tools of consumption function and the multiplier

.3. Invalidates Say's Law
                                  Consumption function helps to invalidate Say's Law which said that supply creates its own demand. Since marginal propensity to consume is less than unity, the whole of the income is not spent on the output produced. According to Say's Law, general over-production in the country is not possible since supply is supposed to create its own demand. This law may hold good in the long run, but not in the short run. In the long run, the market forces establish equilibrium automatically so that demand may be equated to
supply. But no such automatic adjustment is possible in the short run. Hence, for some time there may occur general overproduction. According to Say's Law, an act of producing is simultaneously an act of creating proportional effective demand. There is no doubt production creates value equal to itself but that value is not wholly spent then and there. Since marginal propensity to consume is less than unity, the classical law of markets does not hold good, because the entire output cannot be taken off the market or the entire income is not spent. We knew that marginal propensity to consume is less than unity, i.e., as income increases, consumption increases less than increase in income. Hence, supply, far from creating its own demand, exceeds demand and creates a glut in the market which means general overproduction and mass unemployment.
4. Shows Crucial Importance of Investment.
                                                   Consumption function also underlines the crucial importance of investment. Because propensity to consume is stable, employment can be created only by increasing investment. Consumption function tells us that people spend proportionately less than the increase in their income. Therefore, it becomes necessary to fill the gap between income and consumption by increasing investment; otherwise it will not be profitable to increase output and employment. We also know that consumption function is more or less stable. Hence, it is instability of investment which is responsible for fluctuations in income and employment in a country. It is, therefore, clear that investment plays a vital role in increasing income and employment in a country. If propensity of consumption could also increase, income and employment could be increased even without increasing investment. But, since consumption function is stable, investment is the crucial and initiating determinant of the levels of income and employment.
5. Explains the Declining Marginal Efficiency of Capital.
                                                                          Consumption function explains the declining marginal efficiency of capital. Since consumption function does not increase which could raise the level of consumption expenditure, the prospective yield of capital assets falls. Once the demand for capital goods decreases, the marginal productivity of capital cannot rise unless the marginal propensity to consume rises. Thus, the fall in the marginal productivity could be checked, if the marginal propensity to consume could be increased. Hence, the marginal efficiency tends to decline because the demand for goods is discouraged on account of the marginal propensity to consume not rising or the marginal propensity to save not falling. It is the stability of the marginal propensity to consume which explains the declining marginal efficiency of capital.
6. Explain the Turning Points of the Business Cycle.
                                                              Consumption the turning points of the business cycle. The trade cycle takes the downward course because the marginal propensity to consume is less than unity, i.e the people do not spend proportionately more as their income increases similarly, the consumption function explains the upturn of the business cycle. This is due to the fact that since consumption is stable, people are unable to cut down their consumption expenditure to the full extent of a decrease in their income. It shows the danger of permanent over-saving gap and thus explains the secular decline in the marginal efficiency of capital.
Thus, consumption function occupies a very important place in the theory of employment.


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