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 is consumption, Y is income, and f is the functional relationship. Thus the consumption function indicates a functional relationship between C and Y, where C is the dependent by Y is the independent variable, i.e., C is determined by Y. This relationship is based on the ceteris paribus (other things being equal) assumption, as such only income-consumption relationship is considered and all possible influences on consumption are held constant.
In fact, the propensity to consume or consumption function is a schedule of the various amounts of consumption expenditure corresponding to different levels of income. A hypothetical consumption schedule is given in Table I.
Table I shows that consumption is an increasing function of income because consumption expenditure increases with increase in income. Here it is shown that when income is zero during the depression, people spend out of their past savings on consumption because they must eat in order to live. When income is generated in the economy to the extent of Rs 60 crores, it is not sufficient to meet the consumption expenditure of the community so that the consumption expenditure of Rs 70 crores is still above the income amounting to Rs 60 crores (Rs 10 crores are dis-saved). When both consumption expenditure and income equal Rs 120 crores, it is the basic consumption level. After this, income is shown to increase by 60 crores and consumption by 50 crores. This implies a stable consumption function during the short-run as assumed by Keynes. Figure 1 illustrates the consumption function diagrammatically. In the diagram, income is measured horizontally and consumption is measured vertically. 45° is the unity-line where at all levels income and consumption are equal. The C curve is a linear consumption function based on the assumption that consumption changes by the same amount (Rs 50 crores). Its upward slope to the right indicates that consumption is an increasing function of income. B is the break-even point where C=Y or OY1 = OC1. When income rises to OY1consumption also increases to OC2, but the increase in consumption is less than the increase in income, C1C2 < Y1Y2. The portion of income not consumed is saved as shown by the vertical distance between 45° line and C curve, i.e., SS1. “Thus the consumption function measures not only the amount spent on consumption but also the amount saved. This is because the propensity to save is merely the propensity not to consume. The 45° line may therefore be regarded as a zero-saving line, and the shape and position of the C curve indicate the division of income between consumption and saving.”
The consumption function has two technical attributes or properties:
(i) the average propensity to consume, and (ii) the marginal propensity to consume.
- The Average propensity to Consume
“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 declines as income increases because the proportion of income spent on consumption decreases. But reverse is the case with APS (average propensity to save) which increases with increase in income. Thus the APC also tells us about the the average propensity to save, APS=1—APC.
Diagrammatically, the average propensity to consume is any one point on the C curve. In Figure 2 Panel (A), point R measures the APC of the C curve which is OC1/OY1. The flattening of the C curve to the right shows declining APC.
- The Marginal Propensity to Consume
“The marginal propensity to consume may be defined as the ratio of the change in consumption to the change in income or as the rate of change in the average propensity to consume as income changes.” It can be found by dividing change in consumption by a change in income, or MPC = ∆C/∆Y. The marginal propensity to save can be derived from the MPC by the formula 1–MPC.
KEYNES’S PSYCHOLOGICAL LAW OF CONSUMPTION
Keynes propounded the fundamental psychological law of consumption which forms the basis of the consumption function. He wrote, “The fundamental psychological law upon which we are entitled to depend with great confidence both a prior from our knowledge of human nature and from the detailed facts of experience, is that men are disposed as a rule and on the average to increase their consumption as their income increases but not by as much as the increase in their income.” The law implies that there is a tendency on the part of the people to spend on consumption less than the full increment of income.
Propositions of the Law
This law has three related propositions-
- 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.
- The increased income will be divided in some proportion between consumption expenditure and saving. This follows from the above proposition because when the whole of increased income is not spent on consumption, the remaining is saved. In this way, consumption and saving move together.
- 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 propositions 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.
Diagrammatically, the three propositions are explained in Figure 3.Here, income is measured horizontally and consumption and saving are measured on the vertical axis. C is the consumption function curve and 45° line represents income.
Proposition (1): When income increases from OY0 to OY1 consumption also increases from BY0 to C1Y1 but the increase in consumption is less than the increase in income, i.e., C1Y1 < A1Y1 (=OY1) by A1C1.
Proposition (2): When income increases to OY1 and OY2, it is divided in some proportion between consumption C1Y1 and C2Y2 and saving A1C1 and A2C2 respectively.
Proposition (3): Increases in income to OY1 and OY2 lead to increased consumption C2Y2 > C1Y1 and increased saving A2C2>A1C1 than before. It is clear from the widening area below the C curve and saving gap between 45° line and C curve.
Keynes’s Law is based on the following assumptions:
1. It assumes a Constant Psychological and Institutional Complex. This law is based on the assumption that the psychological and institutional complexes influencing consumption expenditure remain constant. Such complexes are income distribution, tastes, habits, social customs, price movements, population growth, etc. In the short run, they do not change and consumption depends on income alone. The constancy of these complexes is the fundamental cause of the stable consumption function.
2. It assumes the Existence of Normal Conditions. The law holds good under normal conditions. If, however, the economy is faced with abnormal and extraordinary circumstances like war, revolution or hyperinflation, the law will not operate. People may spend the whole of increased income on consumption.
3. It assumes the Existence of a Laissez-faire Capitalist Economy. The law operates in a rich capitalist economy where there is no government intervention. People should be free to spend increased income. In the case of regulation of private enterprise and consumption expenditures by the state, the law breaks down. Thus the law is inoperative in socialist or state controlled and regulated economies.