Economics Class

Consumption Concepts

 

What is consumption function? Discuss its propositions.

Answer:

Consumption function is the name for the general income consumption relationships- Brooman

The psychology of the community is such that when aggregate real income is increased, aggregate consumption is increased but not by so much as income- Keynes

So, consumption function explains the relationship between income and consumption, when income increases consumption also increases but by a smaller amount.

C = F(Y), i.e. consumption is a function of income.

Consumption function shows what expenditure the consumers make on goods and services at each possible level of income.

This law consists of 3 propositions:

v  When aggregate income increases, consumption also increases but by a some what smaller amount. This is because as a person’s income increases, lesser amount is spent out of the subsequent increase in income.

v  When income increases extra income is divided between spending and savings.

v  With the increase in income both spending and savings go up.

 

 

 

Explain: average propensity to consume and marginal propensity to consume.

Answer:

Average propensity to consume is the relationship between total consumption and total income in a given time period. It is the rate of consumption to income.

APC= C/Y

Average propensity to consume= consumption/income

Marginal propensity to consume is the incremental change in consumption to as a result of given incremental in income. It is the ratio of change in consumption to change in income thus.

MPC= ∆C/∆Y

Marginal propensity to consume= change in consumption/change in income

 

 

 

What are the attributes or properties of consumption function?

Answer:

The following are the properties of consumption function:

·         Real income and real consumption are used: the relationship between consumption and income as a rule is presented in terms of real income and real consumption, i.e. the amounts measured along the two axis are at constant prices. Also, the income considered is disposable income.

C= a+ bY, where C is consumption expenditure,

                              ‘a’ and ‘b’ are constants

                               ‘a’ is autonomous consumption(it exists even if income is zero)

                               ‘b’ is marginal propensity to consume

                                Y is the income level

·         The break even point: the break even point is the income level where net saving is zero. Geometrically it is the point where the consumption function curve intersects the 450 line. Below this point is dissaving, i.e. consumption is greater than income and above this point there is positive net saving. At this point APC (average propensity to consume) is 100%, to its left APC is more than 100% and to its right APC is less than 100%.

·         Concept of marginal propensity to consume (MPC): the concept of MPC forms an important attribute of consumption function.

MPC<1

MPC is positive but its value is less than unity. This means that slope of the consumption function will normally be less than one, because when income increases, consumption also increases but not by as much as increase in income.

·         Changes induced by income: it is assumed that normally the consumption function is stable. Therefore, most of the changes in consumption are induced by changes in income.

·         Saving and consumption schedules are mirror twins:

Saving and consumption= disposable income, i.e. saving is the counterpart to consumption function. A decision to consume a part of income is also a decision to save the remaining part of it.

 

 

 

Explain the factors affecting consumption function.

Answer:

Factors affecting consumption function can be studied under two heads- subjective factors and objective factors.

v  Objective Factors

Ø  Distribution of income: this determines the propensities to consume. Normally APC and MPC of the poor is higher than the rich. This is because the poor have a lot of unsatisfied wants and are likely to spend every additional unit of money they obtain to satisfy their wants. On the other hand, the rich have a high standard of living and relatively less urgent wants remain to be satisfied. Additional income in their case is more likely to be saved.

Ø  Fiscal policy: the fiscal policy of the government is related to taxation. Expenditure and public debt affect the propensity to consume. A reduction in taxation will leave more post-tax incomes with tend to increase consumption expenditure. In contrast, an increase in taxation will decrease consumption. Highly progressive tax system decreases inequalities income distribution which increases the propensity to consume.

Ø  Financial policies of corporations: if corporations retain more reserves and distribute less profit in form of dividends, the disposable incomes of the share holders will be smaller, and vice-versa.

Ø  Expectation of future changes: if the consumers expect a rise in prices or shortage of certain goods they tend to purchase it in excess of their current needs. An expectation of a decline in prices will tend to postpone their consumption. Consumption is also influenced by expectation of change in future income. An expectation of future increase in income will increase his consumption.

Ø  Windfall gains or losses: sudden and unexpected gains and losses in income affect consumption function. It is believed that the beneficiaries of windfall gains increase their consumption above the normal level.

Ø  Liquid assets: changes in liquid assets of people affect their consumption. With an increase in their liquid assets, the people have a tendency to increase their consumption.

Ø  Rate of interest: changes in interest rates influence consumption, but it is uncertain as to which way the change will be induced. One possibility is that a higher regard for savings may stimulate savings and decrease consumption.

Ø  Duessenberry hypothesis: from this view, consumption expenditure of an individual is determined not only by his current income but also by hi standard of living in the past. With a decrease in income people find it difficult to adjust their expenditure to changes in income and so their consumption expenditure does not decrease to the same extent as that of income. Secondly, an individual’s consumption depends not only on the amount of his income but also on the size of income of others. The consumption standards of low income groups are considerably influenced by the consumption standards of high income groups.

Ø  Selling effort: it may increase the total volume of consumer’s expenditure.

Ø  Relative prices: changes in prices of relative commodities also affect aggregate demand.

Ø  Volume of wealth: the larger the wealth possessed by a person, the lower would be its marginal utility to him and as such the weaker would be the desire to add to future wealth by reducing current consumption.

Ø  Demographic factors: at a given income level, consumption expenditure may be different for different individuals due to demographic factors like- size of the family, place of residence, occupation, etc. For example, large families tend to spend more, urban families tend to spend more than rural families.

Ø  Terms of consumer credit: easy terms of credit increases volume of purchases of consumer durables.

Ø  Permanent income: a family’s consumption expenditure is determined by its permanent income and not by its current income.

v  Subjective Factors: following subjective factors lead people to refrain from spending.

Ø  Building reserves: to build up reserves against unforeseen circumstances.

Ø  Anticipated needs: to provide for an anticipated future relation between income and the needs of the individual different from that which exists in the present.

Ø  Larger future consumption: a larger real consumption at a later date is preferred to smaller current consumption.

Ø   Security and enjoyment: to enjoy a gradually increasing expenditure and have sense of independence. It satisfies pure miserliness and gives  a power to do things.

Ø  Speculation: to carry out speculative projects.

Ø  Accumulation: to bequeath a fortune.