THEORIES OF CONSUMPTION

This includes;
1.) Life cycle hypothesis
2.) The permanent income hypothesis
3.) Relative income hypothesis
4.) Absolute income hypothesis

LIFE CYCLE HYPOTHESIS by FRANCO MODIGLIANI AND ALBERT ANDO.

According to the theory the typical in individual has an income stream which is relatively low at
the beginning and at the end of his life when his productivity is low and high during the middle
of his life. On the other hand the individual might be expected to maintain a constant or slightly
increasing level of consumption. The constraint of this consumption stream is that the present
value of total consumption does not exceed the present value of total income. This theory
suggests that in the early years of a person’s life, he is a net barrower. In the middle years he
saves and in the late years he dis-saves.

C&Y KEY
1. Net

2 burrower
2. Saves
3
3. Dissaves

TIME
From the diagram: The income curve is a profile of the life time income stream of a typical
person. Measuring time from the year in which he begins full time employment the individual’s
income in each following year rises until it reaches a peak in his middle or working years,
thereafter it declines. The consumption curve shows his life time, consumption stream here
drawn to show a gradually increasing level of consumption from year to year. Assuming that he
plans zero bequests, he will seek to make the present value of his consumption over the life cycle
equal to the present value of his income. From the diagram, the shaded area on the left (Area 1)
shows that the individual’s consumption exceeds his income in the early years of his working
life. He is a net burrower. In the middle years his income exceeds his consumption. He is a saver.
The individual not only repays the debt earlier incurred but acquires assets on which he earns
interest. Finally in the late years, indicated by area three, consumption again exceeds his income;
the individual is a dissaver, however here the dissaving is financed not by burrowing but out of
the savings accumulated during the middle years. The life cycle hypothesis concludes that the
APC ill decrease with higher levels of family income. Thus in budget study in which we draw a
random sample of families and classify them by income, it follows from the life cycle hypothesis
that the family consumption will have an APC that will be lower at higher income levels and
vice visor. This is because the higher income families who are there only because the family
income earner is in his or her middle or late working years. Those in this range of the life cycle
exhibit a relatively low APC correspondingly, the lower income families who are there only
because of their early and late stages of the life cycle as shown from the diagram where the APC
is at his highest at the ends of the range. The life cycle hypothesis then explains the empirical
finding that the APC falls as disposable family income raises.

2.) PERMANENT INCOME HYPOHESIS- M Friedman

Cp= R Yp
Where Cp= permanent consumption
R= constant equal to the apc and mps
Yp= permanent income
Permanent consumption and permanent income are long run trend values of consumption
and income. (Permanent income) is the (present value) of the expected flow of income
from the existing stock of both human and non human wealth over a period of time.
According to Friedman; current measured income for a household or an economy would
be greater or less than p[permanent income, the difference between current measured
income and permanent income is called transitory income that is temporary unexpected
rise or fall in income.

Thus
Y = Yp + Yt
Where
Y = constant measured income
Yp = permanent income
Yt = Transitory income
For example if a family wage earner receives an unexpected special bonus at work in one
year and has no reason to expect the same bonus the following years, this income element
is regarded as positive transitory income. IT raises measured income above permanent
income. On the other hand if the person suffers an unexpected loss of income for example
due to a factory closure as a result of fire, this income element is regarded as negative
transitory income, it reduces measure income below permanent income. In the same way
Friedman’s divides measured consumption into permanent and transitory components.

C = Cp + Ct

C = Current measure
Cp = Permanent consumption
Ct = Transitory consumption
Permanent consumption can be described as the normal or planned level of spending out
of permanent income and maybe different form measured consumption by any unplanned
temporary increases or decreases in consumer spending called transitory consumption.
For example a good purchased because of an attractive sale price or a normal purchase
postponed due to an availability of the good are examples of positive and negative
transitory consumption. According to Friedman, there is no correlation between transitory
income and permanent income. Friedman assumes that there is no relationship between
transitory consumption and transitory income, so that increase in transitory increase will
not imply increases to the individual consumption thus from these assumptions.
C = Cp = RYp
Where
C = Current measured consumption
Cp = Permanent consumption
Yp = Permanent income