As the demand for a good depends upon its price, similarly consumption of a community depends upon the level of income. In other words, consumption is a function of income. The consumption function relates the amount of consumption to the level of income. When the income of a community rise, consumption also rises. How much consumption rises in response to a given increase in income depends upon the propensity to consume or consumption function. It should be borne in mind that the consumption function or the propensity to consume is the whole schedule which describes the amount of consumption at various levels of income. The consumption function shows the relationship between the level of consumption expenditures and the level of disposable personal income. This concept, introduced by Keynes, is base on the hypothesis that is a stable empirical relationship between consumption and income. For example,
c=f(y)
Where, c stands for consumption expenditure and y stand for national income. It should be borne in mind that consumption function or propensity to consume is the whole schedule which describes the amount of consumption at various levels of income.
There are two important concept of propensity to consume, the one being average Propensity to consume and the other marginal propensity to consume. They should be carefully distinguished, for they are equal in some cases but different in other.
The marginal propensity to consume (MPC) is the amount of extra consumption generated by an extra dollar of disposable income. On the other hand, the average propensity to consume (APC) is the proportion of total disposable income that goes on consumption. According to formula, MPC is the ratio of change in consumption to the change in income, i.e. Graphically, MPC is given by the slope of the consumption function where APC is not the slope of the consumption function.
The saving function shows the relationship between the level of saving and income. Became, what is saved equals what is not consumed, savings and consumption schedules are mirror.
An important relationship between income and saving is described by the concept of average propensity to save is the proportion of disposal income that is saved. So APC is the proportion of disposable income that is saved. Arithmetically,
APS=Saving/Disposable Income=S/Y.
This implies that APS will increase as income rises.
Let us derive an important relationship between APC and APS. Restating below the relation that income is either consumed or save:
C+S=Y
C/Y+S/Y=Y/Y
C/Y+S/Y= 1
APC+APS=1
This means, for example, that if a society consumer 75% of its disposable income, that is, APC=.75 then it will save 25% of its disposable income.
Whereas average propensity to save indicates the proportion of income that is saved, marginal propensity to save represent how much of the additional disposable income is devoted to saving. The marginal propensity to save is therefore change in savings induced by a change in the disposable income. Since the additional income is either consumed or saved, any change in income must induce either change in consumption or change in saving. Thus,
Change in C+ Change in S=Change in Y/ Change in Y
Change in C/ Change in Y+ Change in S/ Change in Y=Change in Y/Change in Y
Change in C/ Change in Y+ Change in S/ Change in Y=1
MPC+MPS=1
In, for example, disposable income increases form 10000 to 12000, that is Change in Y=2000, the saving increases by 500. Putting theses values in equation, we get
MPC=1-MPS
=1-Change in S/Change in Y
=1-500/2000
=1-0.25
=0.75
So the society must consumed 75% of disposal income.
Keynes’s propounded a basic law about the consumption function. This has been described as psychological law of consumption by Prof Kurihara. According to this psychological law of consumption, when the aggregate income increases but by a somewhat smaller amount. It means that out of the increment in income, a part is saved and not consumed. In other words, marginal propensity to consume is less then one. We have explained above the various subjects and object factors which influence the propensity to consume. Many factors are responsible which induce the people to save somewhat out of the extra income. It has also been established by empirical evidence that people on average do not consume the whole of their increment in income.
Keynes in his General Theory published in 1936 laid the foundation of modern macroeconomics. Theory of consumption function plays a crucial role in his theory of income and employment.
Keynes Proposition:
Consumption expenditure depends mainly on absolute income of the current period. Consumption expenditure does not have proportional relationship with income.APC falls as income increases. Since APC falls as income increases, MPC is less than APC at each income level.
The Keynes Law of consumption can be expressed in the following form of consumption:
C=a + by
Where c=consumption function and yd=real disposable income. The parameter a and b are constant, where a is the intercept term and b is the marginal propensity to consume (MPC=Change in C/Y). The Keynesian consumption function is depicted in the following way.
B=MPC=Change in C/Change in Y and APC=C/Y
In the figure, we have shown a linear consumption function, with an intercept term. In this form of consumption function, though marginal propensity to consumption (MPC) is constant, propensity to consume (APC) is declining with the increase in income. Because, a tangent indicating average propensity to consume (APC) drawn at point B at higher income level y2 has a relatively less slope then tangent drone at point A at lower income levelY1. Moreover assumption implies a progressively large proportion of national income would be saved. Therefore, to achieve and maintain Equilibrium at full employment level of income, increasing proportion op national income is needed to be invested. Otherwise, problem of demand effluent would emerge.
Empirical studies of long-term time’s series data of the US economy for the period 1869-1938 made by noted American economist Kuznets estimated a consumption function which contradicts this data. On the basis of empirical study of time series data of the US Kuznets has found that there is proportion relation between consumption and income i.e. the long-run APC is constant and therefore MPC =APC in the long run consumption function and the two remain constant . As this is contrary to Keynes theory of consumption function, this became a puzzle for the economists.
An American economist J.S Duisenberg put forward the theory of consumer behavior which is called Relative Income Hypothesis. According to this theory, consumption of an individual is not the function of his absolute income but of his relative position in the income distribution in a society.
Relative Income theory of consumption states that, if the proportion of income devoted to consumption of the average family at each income level remains the same as its income increases, the aggregates consumption of the community as proportion of its income will also remain constant though its absolute consumption and absolute savings will increase with the absolute increase in income. This theory also suggests that as income increases consumption function curve shifts above so that average propensity to consume (APC) remains constant.
By emphasizing relative income as determinant of consumption, the relative income hypothesis suggests that individuals try to imitate the consumption levels of their neighbors in a particular community. This is called Demonstration effect or Duisenberg effect. Two things follow from this. First, the APC does not fall. Secondly, a family with a given income would devote more of his income to consumption at its living in a community in which that income regarded as relatively low because of the working of demonstration effect.
Duisenberg’s relative income hypothesis suggests that when income of individuals falls, their consumption expenditure does not fall much. This is often called a ratchet effect. This is partly due to the fact that they become accustomed to their previous higher level of consumption and it is quite hard and difficult to reduce their consumption expenditure when their income has fallen. They are able to maintain their consumption level by reducing their saving.
Life cycle theory of consumption has been put forward by Modigliani and Audi. According to this theory, the consumption in any period is not the function of current income of that period but of the whole life-time expected income.
Assumptions:
Life cycle hypothec is has been depicted in the following figure.
Here, working age = (65years-15years) =50years.
Expected life-time=75years.
Disserving before the age of 15 years =Change in ACY.
Disserving before the age of 65 years=Change in BCY.
Total disserving = Change in ACY + Change in BCY.
Total saving =Change in AHB.
Income line=YY
Consumption curve = CC, which is slightly increasing as the individual grows old.
In the figure, horizontal axis measures the life-time of the individual axis measures the income and consumption. In is assumed that our individual enters into labor force (i.e. working life) at the age of 15 years and up to the age of 28 years his income is less than his consumption. To finance his excess consumption over his income, he may be borrowing from other. Beyond the age of 28 years and up to the age of 65 years his income exceeds his consumption. With these saving (i.e. income is greater than consumption) he will build up assets or wealth.
He many uses savings or wealth to pay off his debt incurred by him in the early stage of his working life .Another important motive is to provide for his consumption after retirement when his income drops below his level of consumption.
Permanent Income Theory of consumption has been put forward by Milton Friedman. According to Friedman consumption is deter mind by long-term expected income rather than currant level of income. And Friedman defined long term expected income as permanent income on the basis of which people make their consumption plants.
Relationship between consumption and permanent Income:
Friedman thinks that consumption is proportional toper anent income, i.e.
cP = kyP----------------1
Where, yP stand for permanent income cP stands for permanent consumption and k stand for the proportion of permanent income that is consumed.
In addition to permanent income, the individual’s income may contain a transitory component which have not much effect on consumption,
yM = yP+yT--------------2
Where, yM stands for (current) measured income in a period, yP stands for permanent Income and yT stand for trausitory income.
Here, permanent income can be measured as under,
yP=yt-1+a(yt-yt-1)-----------3
yP=yt-1+ayt-ayt-1
yP=ayt+(i-a)yt-1-----------4
Where a is a proportion of change in income between the last year (t-1) and the current year(t), yt is the level of income in current year and yt-1 is the last year’s income.
Now, we can describe the precise relationship between consumption and income both in the shortrun and the long- run as under,
C=kyP
C=k[ayt+(1-a)yt-1]
C=kayt+k (1-a)yt-1-------5
Where ka is the marginal propensity to consume in the short run and k(1-a)yt-1 is the intercept of the short run consumption function. This is illustrated in the following figure:
It shall be seen in this figure that permanent consumption function is represented by the long run consumption function curve cLR. This consumption function shows the proportional relationship between consumption and income and is a straight line passing through the origin which implies that APC is constant and is equal to MPC. It will also be seen that short run consumption function curves are flatter as compared to the long run consumption function curve indicating that the short run MPC is lower than run MPC.
No comments:
Post a Comment