Consumption function

Concept & Meaning

 Consumption Function refers to the general disposable income
and consumption expenditure relationship.

 The major determinants of consumption are

Disposable income,
Accumulated wealth,
Expected future income,
Price level,
Interest rate etc.
 It is quantitative relationship between consumption and
disposable income.

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 Mathematically,
CE = F (Yd, W, Ye, PI, i etc)………….(i)

Where,
C = Consumption
Yd = Disposable income
W = Wealth
Ye = Expected future income
PI = Price level
i = Interest rate

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 Out of these determinants
Yd is the most influencing determinant which is taken as
quantitative relationship between consumption expenditure
and disposable income

Mathematically,
CE = F (Yd)……………………. (ii)
Linear form of consumption function as :
C = a + bYd…………………….(iii)
Where,
a = autonomous consumption yd = Disposable income
b = marginal propensity to consume O < mpc < 1, and b
>0
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 Consumption function can be broadly classified into short run
consumption function and long run consumption function.

Short run consumption function is

C = a + bYd …………….. (iii)

Long run consumption function

C = bYd ………………….. (iv)
Graphically

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Keynes’s psychological law of consumption
 Consumption function is a key element in the Keynesian theory
of income determination

 Psychological law states that to increase the consumption as

income increases, but not by as much as the increase in
income.

 The psychological law of consumption translates into the

Keynesian consumption function as
C = a + byd , ………………….(v)
a›0
0‹b‹1

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 Consumption depends upon following assumptions as
1. Constant psychological and institution factor.
2. There is existence of normal circumstances i.e
no war, no revolution, no high inflation etc
3. Free enterprise economy.

Graphically,

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 Average Propensity to Consume (APC):
Consumption is not a constant function of disposable
income. The ratio of consumption and income is termed as APC
Formula,

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 For example, if the aggregate income of an economy is $1000
millions and aggregate consumption is $800 millions.
Then, APC is expressed as
APC = C/ Yd
= 0.80
= 80%
 It implies that economy spends 80% of its income on consumption. Average
propensity to consume (APC) is expressed as percentage of income
consumed.

 Total income of an individual is either consumed or saved or both.

Y=C+S
1 = APC + APS
1 = APC + APS……………………………..(ii)
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 Marginal Propensity to Consume

Marginal Propensity to Consume

….. is the extra amount that people consume when they
receive an extra amount of disposable income.

For example,
Marginal cost (MC) means the additional cost of producing an
extra unit of product. MPC is
therefore, the additional or extra consumption that results from
extra dollars of disposable income.

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 The MPC can be calculated by dividing change in
consumption by change in disposable income.

MPC = ∆C/ ∆Yd ………………(i)

Where,
∆C = change in consumption
∆Yd = change in Disposable Income
Yt = Income in time period t
Yt-1 = Income in time period t-1
Ct = Consumption in time period t
Ct-1 = Consumption in time period t-1

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For example
if income is increases from $1000 million to $1200 million
and consumption increase from $800 to $950 million,
then MPC is expressed as,
MPC = ∆C/ ∆Yd
= 150/200
= 0.75
= 75%

This implies that consumption increases by 75% of increased

income.
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 We have,
Y = C+S
Using change in both side,
or, ∆Y = ∆C + ∆S
Dividing both side by ∆Y
or, ∆Y/ ∆Y = ∆C/ ∆Y + ∆S/ ∆Y
or, 1 = MPC + MPS
MPC + MPS = 1………….(i)

Thus, marginal propensity to consume (MPC) + marginal

propensity to save (MPS) equals to 1
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 MPC and MPS can be calculated from following table:
Unit(0) Disposable Consumption MPC (3) Net Saving MPS (5)
Income(1) expenditure (1-2)
(2)
A 24000 24110 …… -110 ……
B 25000 25000 =0.89 0 = 0.11
C 26000 25850 =0.85 150 = 0.15
D 27000 26600 = 0.75 400 = 0.25
E 28000 27240 = 0.64 760 = 0.36
F 29000 27830 = 0.59 1170 = 0.41
G 30000 28360 = 0.53 1640 = 0.47

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 Determinants of consumption Function
 Keynes has divided the factors influencing the consumption function into two
parts i.e
Subjective factors
Objective factors.

 The internal factors influencing the consumption function is known as

subjective factors

where as the external factors that influencing the consumption function is

known as objective factors.

 Subjective factors: This factor is basically related with psychological

feelings. The subjective factors play an important role in determining the
level of consumption function.

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 Major subjective factors
Security motive
old age allowances, unemployment allowances, disable allowances etc
helps to increase the consumption expenditure or consumption function
Demonstration effects
People are influenced by the consumption of other people and try to
adopt similar consumption practice
Increasing social status
People are motivated to save more and accumulate large wealth will
increase their social status. This helps to reduce consumption
expenditure and increase saving
Financial prudence
Business firm desire to save more increase undistributed corporate profit
for the expansion and modernization of business

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 External factors that influencing the consumption function is known as
objective factors.

 These factors are real factors and are measurable and changed easily
in the short run. Following factors are the objective factors
Income of people
Income Distribution
Price level
Wages level
Interest rate
Fiscal policy

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Measures to Increase propensity to consume (MPC)

 The short-run consumption function is stable because it is very

difficult to change in the short period. Psychological and institutional
factors affecting propensity to consume.

 In the long-run, it is possible to raise the propensity to consume

through the following measures:
Interpersonal comparison
Wage policy
Social security
Credit facilities
Urbanization and colonization
Advertisement and publicity
Income Redistribution etc.
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 Saving Function
 Meaning. Saving is defined as the excess of income over
consumption expenditure. The concept of saving is closely related to
the concept of consumption. 

 Saving is the part of income that is not consumed. Saving function or

the propensity to save expresses the relationship between saving and
the level of income
S = f (Yd)……………(i)
S = -a + (1-b)Yd………..(ii)
Where,
-a = autonomous saving
(1-b) = marginal propensity to save

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Graphically,

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 Determinants of Saving
 These explains the empirical observations that total
saving accounts for a fairly stable share of total income
as:
1. Income Distribution
2. Consumption Motivations
3. Wealth
4. Habit
5. Population
6. Objective and Institutional Factors
7. Subjective Motivations for Savings etc.

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 Paradox of thrift
 Definition: Paradox of thrift was popularized by the
renowned economist John Maynard Keynes.

 It states that individuals try to save more during an

economic recession, which essentially leads to a fall in
aggregate demand and hence in economic growth
decline.

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 Investment function
 Generally, investment means buying of existing shares, bond or
debentures of a public limited company. But buying of existing
shares, bonds, and debentures are only the transfer of assets
from one person to another.

 Investment is the new additions to the stock of physical capital

such as plant, machineries, new factories etc. that create
income and employment. Therefore, investment means the
additions to the stock of physical capital.

 According to Peterson, “investment expenditure includes

expenditure for producers’ durable equipments, new
constructions and the change in inventories”.

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 Types of Investment:
1. Gross and Net Investment
GI = NI + Depreciation
NI = GI – Depreciation
2. Private and public Investment
Investment made by private sector is Private Investment.
Investment made by Govt. sector is Public Investment.
3. Ex-ante and ex-post Investment
The estimated or planned investment is called ex-ante
investment.
The actual investment or revalued investment is called ex-post
investment.

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4. Induced Investment: Investment in inventories and equipment
which is derived from and varies with changes in final output or Income
is known as induced investment.

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Autonomous Investment : It consists of expenditures in a country or
region that is independent of economic growth. Investments made for
the betterment of society not for profit making.

Autonomous investment is the opposite of induced investment, which

is not mandatory or compulsory.

Aggregate Investment = Induced Investment + Autonomous Investment

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 Determinants of Investment

 There are mainly two determinants of investment. They are

marginal efficiency of capital (MEC) and rate of interest.

Marginal Efficiency of Capital (MEC)

Rate of interest

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 Other determinants
 Short – run Factors:  Long – Run factors:
1. Expected demand and 1. Economic Policy
price 2. Population
2. Propensity to consume 3. Technological Progress
4. Supply of Capital
3. Change in income equipments
4. Taxation 5. Development of new areas
5. State of business 6. New products
confidence 7. Liquid assets
6. Political Stability 8. Situation of current
investment

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 Marginal Efficiency of Capital

 J.M. Keynes 1st introduced the term Marginal Efficiency

of Capital (MEC) in 1936. It is alternative method of
investment decision. MEC is also known as Internal Rate
of Return (IRR).

 According to Keynes, “The marginal efficiency of capital is

that rate of discount which makes the present value of the
series of annuities given by return expected from the capital
assets during its life just equal to its supply price”.

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 Suppose, that he supply price (cost) of a machine is Rs.
2000 and it has useful economic life is 2years. In the 1st year
the machinery is expected to yield income of Rs. 1100 and
in the 2nd year Rs. 1210. We can calculate the value of (r) or,
Marginal Efficiency of Capital (MEC) with the help of above
formula.

By definition of MEC, we have

Supply price (cost) = Discounted prospective yield

C = R1/(1+r) + R2/ (1+r)2
2000 = 1100/(1+r)1 + 1210/ (1+r)2
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 On calculating the value of (r) by trail or, error method by using
the financial annuity table in the above equation the value of r
is found to be equal to 10.
 Thus, the marginal efficiency of capital (MEC) equal to 10.

In order to verify, let us put the value of r in above equation,

2000 = 1100/(1+r) + 1210/ (1+r)2
2000 = 1100/(1+0.10) + 1210/ (1+0.10)2
2000 = 1000 + 1000
2000 = 2000
 Thus, the supply price of capital equals the present value of
the discounted future yield.
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Graphically,

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 Decision rule:-
Once, MEC or IRR is estimated, Investment decision can be
taken by comparing MEC with the market rate of interest
(r ). The general investment decision rules are:-

If MEC > i Investment project is acceptable.

If MEC = i Project is acceptable only by non-profit
organization.
If MEC < i Then, the project is rejected

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 Marginal efficiency of investment
 MEC, in economics, expected rates of return on
investment as additional units of investment are made
under specified conditions and over a stated period of time.

 A comparison of these rates with the going rate of interest

may be used to indicate the profitability of investment.

 The rate of return is computed as the rate at which the

expected stream of future earnings from an investment
project must be discounted to make their Present Value
equal to the Cost of the Project.

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 Logically, investment would be undertaken as long as the
marginal efficiency of each additional investment exceeded
the interest rate.

 If the interest rate were higher, investment would be

unprofitable because the cost of borrowing the necessary
funds would exceed the returns on the investment. 

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Graphically,

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 Investment multiplier

Concept:
 The theory of multiplier occupies an important place in the
modern theory of income and employment

 The concept of multiplier was first of all developed by F.A. Kahn

in the early 1930s. But Keynes later further refined it. F.A.
Kahn developed the concept of multiplier with reference to the
increase in employment.

 Keynes’ multiplier is also known as investment or income

multiplier.

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 For example, If as a result of the investment of Rs.
100 crores, the national income increases by Rs.
300 crores, multiplier is equal to 3

 The multiplier is, therefore, the ratio of increment in

income to the increment in investment

 Therefore,
k = ∆Y/∆I where k stands for multiplier.

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 Derivation of Investment Multiplier

Y= C+I+G+(X-M)
Y= a+ byd +I+G+(X-M)
Investment multiplier
Government expenditure Multiplier
Tax Multiplier

Two sector
Three sector
Four sector

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 leakages of multiplier
 leakages of multiplier: It deals the idle saving which leads to
equivalent fall in MPC. It results into fall in the value
of multiplier.
 Higher the MPS greater will be the leakage from income
propagation and smaller is the value of multiplier.

 The five major leakage with multiplier process are as follows:

1. Paying off debts
2. Holding of idle cash balances
3. Imports
4. Taxation
5. Increase in prices. 

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Paying off debts: The first leakage in the multiplier process occurs in the
form of payment of debts by the people, especially by businessmen. The
incomes used for paying back the debts do not get spent on consumer
goods and services and therefore leak away from the income stream.
This reduces the size of the multiplier.

Holding of idle cash balances: If the people hold a part of their increment
in income as idle cash balances and do not use them for consumption,
they also constitute leakage in the multiplier process.

Imports: The proportion of increments in income spent on the imports of

consumer goods will generate income in other countries and will not help
in raising income and output in the domestic economy.
Therefore, imports constitute another important leakage in the multiplier
process.
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Taxation: The increments in income which the people receive as a
result of increase in investment are also in part used for pay­ment
of taxes.
Therefore, the money used for payment of taxes does not appear
in the successive rounds of consumption expenditure in the
multiplier process, and therefore multiplier is reduced 
Increase in prices: Price inflation constitutes another important
leakage in multiplier. When output of consumer goods cannot be
easily increased, a part of the increase in the money income and
aggregate demand raises prices of the goods rather than their
output. Therefore, the multiplier is reduced to the extent of price
inflation

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 Assignment on

Relationship between MEC & MEI

Measures to stimulate investment
Importance of Multiplier

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The End

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