Consumption Function
By Dr Garima Dikshit
The consumption function is one of the important tools of Keynes’ economics. According to Keynes consumption is a function of absolute current income and depends more on real income rather than the money income. So, the consumption function shows a clear relationship between income and consumption of the consumer. Consumption function shows how consumption patterns of consumer changes with the change in income which is also called the propensity to consume. If consumption is represented by C and Income by Y then the propensity to consume will be C(Y). The consumption means the amount spent on consumption expenditure at a given level of income while consumption function or the propensity to consume implies the whole schedule showing consumption expenditure at various levels of income.
Income and consumption have a positive relationship. When income increases consumption also increases but not in the same proportion. Suppose original income was 100 crores and consumption was 70 crores. The income further increases by 20 crores, now the increase in consumption expenditure will be less than an increase in income. In the given figure 1, income is measured on the OX axis and consumption on the OY axis. OM line makes an angle of 45 degree. All points on OM are at an equal distance both from OX and OY. If we treat OM as an income-consumption curve, then it means that both income and consumption increase in an equal amount i.e. increase in consumption is equal to the increase in income however, it does not happen like that. If the income increases by 50% the consumption expenditure do not increase by 50%, but by something less than this. Therefore the income-consumption curve will be somewhere lower than OM. ON is another straight line lower than OM it indicates marginal propensity to consume which is according to ON curve is constant at all levels of income, but in actual life, MPC goes on declining with every increase in income of the consumer. So, MPC is better shown by the curve OP. the reason for declining MPC is with every increase in income the most urgent want of consumer get full filled and any further increase in income goes to increase savings. Therefore based on the diagram the distance between OM and OP curve represents savings.
Average Propensity to Consume (APC) and Marginal Propensity to Consume (MPC):
The concept of the average propensity to consume indicates the ratio of aggregate consumption expenditure to aggregate income i.e. C/Y let suppose the aggregate income of the consumer is 1000 crore and expenditure on consumption is 800 crores then APC will be C/Y i.e. 800/1000 or 80 per cent. This implies that the community spends 80 per cent of its income on consumption.
Marginal Propensity to Consume, on the other hand, indicates a change in consumption due to a change in income. The MPC is calculated by dividing the increment or decrement in the consumption by the increment or decrement in the income. Thus the formula is Change in C/Change in Y. for example the aggregate income increases by Rs. 10 crores and consumption expenditure by 6 crores then the marginal propensity to consume will be 0.6 i.e. (6/10).
Relationship between APC and MPC:
As the income rises, the MPC will decline. The APC will also fall, but MPC falls to a greater extent than the APC. In other words, both the propensities decline with an increase in income, although the decline in one case is greater than in the other case.
The marginal propensity to consume, as said earlier, is higher in the case of poor than in the case of rich people. The greater is any man’s income, the more his basic needs will have already been met, and greater will be the tendency for him to save to provide for the future.
The marginal propensity to save of the richer class shall be greater than that of the poor class. Simply because with all the basic and major wants are satisfied any increase in income will automatically get directed towards savings.
Derivation of Saving Function from Consumption Function:
That part of income that is not consumed is saved. Average Propensity to Save (APS) indicates the proportion of disposable income that is saved. APS = S/Y, where S represents savings, and Y represents income. As we have discussed above that with the increase in income the average propensity to consume falls. This implies that APS will increase since
APC + APS = 1, therefore
Marginal Propensity to Save (MPS) represents how much of the additional disposable income is devoted to savings.
MPS = Change in Savings/ Change in Income
The sum of MPS and MPC is equal to one
Figure 2 shows the saving curve in the lower panel. SS curve indicates the gap between the consumption curve CC and the income curve OZ in the upper panel. It can be seen that up to income load OY 1, consumption exceeds savings i.e. there are negative savings or dis-savings. Beyond income level OY 1, there are positive savings. In the upper panel, APC falls with an increase in income, but APS rises as income increases. The MPS is shown in the lower panel. When disposable income increases from OY 1 to OY 2, savings increase by Y 2 T.
Originally published at https://www.studentsofeconomics.com.
