The consumption function or propensity to consume is a mathematical formula introduced by John Maynard Keynes, the father of modern day macroeconomic theory. The formula shows the relationship between real disposable income and total consumption.
The consumption function shows the willingness of consumers to expend on consumer goods and services at different levels of disposable income.
Symbolically, the functional relationship between income and consumption is expressed as C= f(Y)
Where, C= Consumption
Here, C is the dependent variable and Y is the independent variable. This means that the level of consumption is determined by the level of income. As the income increases, consumption increases as well. However, the consumption level always remains lower than the income level.
The increase in income not only increases the consumption level, it also leads to a rise in the level of savings made by the consumers.
The table below is a representation of consumption function schedule
|Disposable Income||Consumption (C)||Savings (S)|
Table 1: Consumption Function Schedule
The table shows the various levels of consumption pattern in correspondence to the different levels of disposable income. We can see that with an increment in the level of income, there is a gradual increment in the level of consumption expenditure and personal saving.
Technical Attributes of Consumption Function
In understanding the consumption function or the propensity to consume, Keynes considered two of its technical attributes:
- Average Propensity to Consume (APC)
- Marginal Propensity to Consume (MPC)
Average Propensity to Consume (APC)
The average propensity to consume (ACP) is defined as a ratio of total consumption to total income in a given period of time. It is calculated by dividing the amount of consumption (C) by disposable income (Y) for any given level of income.
Where, C= Consumption; Y= Income
For example, when the disposable income of the nation is $180 and consumption expenditure is $170, we can calculate APC as
= 0.92 or 92%
This shows that out of the total disposable income for the year, 92% will be used for consumption while, the rest is used for saving. The APC declines as income increases because the proportion of income spent on consumption decreases.
This can be explained with the diagram below
In the figure, CC represents the consumption curve. At point E,
Thus, APC implies a point on the curve C which indicates the ratio of income and consumption. The CC curve is made up of a series of such points.
Marginal Propensity to Consume (MPC)
The marginal propensity to consume (MPC) is defined as the ratio of the change in consumption to the change in income. It is also referred to as the rate of change in the APC that occurs as a change in income. It is calculated by dividing the change in consumption (ΔC) by the change in income (ΔY).
Where, ΔC= Change in consumption; ΔY= Change in income
For example, if
This implies that with an increment of one extra dollar of disposable income, the household will spend $83 and save $17.
The marginal propensity to consume can be explained using the diagram below
In the diagram, MPC is measured by the slope of the consumption curve. Here,
Generally, it is assumed that value of MPC for the richer sector of the economy would be less than that for the poorer section. This means, if income increases by $1 for both the parties, the propensity to consume would be less for the richer section than the poorer section.
Determinants of Consumption Function
There are a number of determinants, both subjective and objective which determine the position of consumption function.
I. Psychological Characteristics of Human Nature
The subjective factors affecting consumption function include psychological characteristics of human desires or wants. Consumption and saving behavior of individuals with regards to increased income is dependent on their psychological motives.
Social practices and modern social order relating to the behavior of business firms concerning wage and payment of dividend and retained earnings are also responsible determining the consumption function.
Keynes has highlighted some motives on such human nature:
a. Precaution Motives
Individuals would want to prepare themselves to any unseen emergencies like sickness, unemployment, accidents, etc. So they keep reserves for such situations.
ness, unemployment, accidents, etc. So they keep reserves for such situations.
b. The Motive of Foresight
Foresight motives include human needs related to future such as old age support, educational needs for children, etc.
c. Standard of Living
Individuals would want to improve their standard of living. For this, they would increase their level of savings for future undertakings.
d. The Motive of Independence
The motive to be independent is a drive towards consumption function as it leads to more saving and less consumption at present.
e. The Motive of Enterprise
Individuals may have a desire to start their own business enterprise. So, they cut down their present consumption expenses and make more savings.
The objective factors that drive the consumption function include:
a. Real Income
Real income is the basic factor that determines community’s propensity to consume. When real income of the community increases, consumption expenditure also increases but only to minimum level. This shifts the consumption function upwards.
b. Distribution of Wealth
Unequal distribution of wealth leads to an unequal consumption function. People with low income group have high propensity to consume in comparison to the rich group. Equal distribution of income raises the propensity to consume.
c. Expectation of Change
The propensity to consume is also affected by the expectation of any change in the future. For instance, in case there are chances of price rise in any market commodity, consumers are likely to spend more on the consumption of that commodity at present. Consumers would buy more of the commodity to hoard it until future, the goods that are non-perishable. Thus, the ratio of consumption to current income will increase, which shifts the consumption function upwards.
d. Changes in Fiscal Policy
Fiscal policy is related to how the government makes it expense and the tax structure imposed on consumer income. If the tax payable is greater, disposable income of the consumers decrease and so does their spending, and vice versa.
e. Change in Interest Rates
Increased rate of interest induces people to save more and spend less on consumption. So, increased rate of interest increases the propensity to consume.
f. Credit Facilities
Easy availability of credit facilities incudes consumers to consume more due to easy access to cash. On the other hand, if the credit facilities are not easily available, consumers spend less.
g. Windfall Gains and Losses
When consumers earn huge profit, they tend to consume more as income increases. On the other hand, when loss occurs, consumers spend loss as their income falls