Managerial Economics-II Unit-2 Consumption Analysis

Unit-3: Consumption Analysis

Prof P.Naresh KumarLecturer in Economics

SIBER, Kolhapur-416004Mail-id: srivastavb4u@gmail.com

1. Classical vs Keynesian Keynesian2. Psychological Law of Consumption3. Properties of Consumption Function4. APC, APS, MPC, MPS5. Importance of Consumption Function6. MPC in underdeveloped countries

One of the important tools of the Keynesian economics is the consumption function.

Consumption Function: Consumption function refers to income –consumption relationship. Itis a “functional relationship between two aggregates i.e. total consumption and total income”.Symbolically the relationship is represented as

C=f(Y)

Where C= ConsumptionY=Incomef= Functional relationship

Thus consumption function indicates a functional relationship between C and Y, where C is thedependent variable and Y is the independent variable. This relationship is based on the ceterisparibus (other things being equal) assumption.

Consumption function is a schedule of the various amounts of consumption expenditurecorresponding to different levels of income. A hypothetical consumption schedule is given below.Income(in Rs.)

ConsumptionC= f (Y)

060120180240300360

2070120170220270320

Income is shown to increase by Rs 60 crores and consumption by 50 crores. This implies a stableconsumption function during the short-run as assumed by Keynes.However, Keynes assumed a linear straight line consumption function. SymbolicallyC = a + b YWhere C = Aggregate consumption Expenditurea = Autonomous consumption expenditureb = Slope= Change in consumption expenditure due to change in incomeIn the diagram, income is measured horizontally and consumption is measured vertically. The450 line is the unity line where are all levels income and consumption are equal. The C curve is theconsumption function based on the consumption changes by the same amount. Its upward slope tothe right indicates that consumption is an increasing function of income B is the break even pointwhere C=Y. the 450 line may therefore regarded as zero-saving line.

Properties of Consumption Function:The consumption function has two technical attributes:

i. The Average Propensity to Consume (APC)ii. The Marginal Propensity to Consume (MPC)

1. The Average Propensity to Consume (APC):The average propensity to consume may be defined as the “ratio of consumption to anyparticular level of income”. Symbolically

APC= C / YIt is expressed as the percentage or proportion of income consumed. The APC at various incomelevels is shown in column 3 of the table.The APC declines as income increases because the proportion spent on consumption decreases.Consider the consumption function C= a+ b Y

APC = C/Y= (a + bY) / Y= (a/Y) + b

2. Marginal Propensity to Consume (MPC):Marginal Propensity to consume may be defined as the “ratio of change in consumption tochange in income or as the rate of change in the average propensity to consume as incomeincreases”.

MPC = ∆C/∆YThe MPC is constant at all levels of income as shown in table column-4. It is 0.83 or 83%.Consider the consumption function C = a + bY

MPC = ∆C/∆Y=dC/dY=d(a+bY)/dY=0 + b=b

Therefore MPC=b

Diagrammatically MPC is measured as the slope of the consumption (c ) curveNote: APC = (a/Y) + b

= (a/y) +MPCTherefore APC > MPCIncome (Y) Consumption (c ) APC=C/Y MPC=∆C/∆Y

120 120 1.00 -

180 170 0.94 0.83

240 220 0.92 0.83

300 270 0.90 0.83

360 320 0.89 0.83

Significance of MPC:The MPC is the rate of change in the APC. When income increases, the MPC falls but more thanAPC, and contrarily when income falls, the MPC rises and APC also rises but ata slower rate thanthe former. Such changes are only possible during cyclical fluctuations where as in the short-runthere is change in the MPC and MPC < APC.Keynes is concerned primarily with the MPC, for his analysis pertains to the short-run whilethe APC is useful in the long-run analysis. The post Keynesian economists have come to theconclusion that over the long-run APC and MPC are equal and approximate 0.9. in the Keynesiananalysis the MPC is given more prominence. Its value is assumed to be positive and less thanunity which means that when income increases the whole of it is not spent on consumption. Onthe contrary, when income falls, consumption expenditure does not decline in the same proportionand never becomes zero.The Keynesian hypothesis is that MPC is positive but less than unity. 0< MPC< 1 is of practicaland analytical significance.

MPC is low in case of rich people and high in the case of the poor. This accounts for high MPCin underdeveloped countries and low in advanced countries.

Keynesian Psychological Law of Consumption:Keynes propounded the fundamental psychological law of consumption which forms the basis ofconsumption function. He wrote, from our knowledge of human nature and from the detailed factsof experience, “Men are disposed as a rule and on the average to increase their consumptionas their income increases but not by as much as the increase in their income”. The law impliesthat there is a tendency on the part of the people to spend on consumption less than the fullincrement of income.

Properties of the law:This law has three related propositions.

1. 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 needto spend more on consumer goods diminishes. It does not mean that the consumptionexpenditure falls with the increase in income. In fact, the consumption expenditureincreases with increase in income but less than proportionately.

∆C < ∆Y Y

2. The increased income will be divided in some proportion between consumptionexpenditure and saving. This follows from the above proposition because when the wholeof increased income is not spent on consumption, the remaining is saved. In this way,consumption and saving move together.

∆Y = ∆C + ∆S3. Increase in income always leads to increase in consumption and saving. This means that

income is unlikely to lead either to fall in consumption or saving than before.

The three propositions of the law can be explained with the help of the following table.

Income Consumption Saving: S=Y-C

0 20 -20

60 70 -10

120 120 0

180 170 10

240 220 20

300 270 30

360 320 40

Saving Function: Saving function is the functional relationship between aggregate saving ndaggregate income. Symbolically

S = f (Y)More specifically S= f (Yd) where Yd = Y-T

Properties of Saving Function:1. Average Propensity to Save:

It may be defined as the ratio of saving to income. It is the counterpart of APC.APS = S/Y

2. Marginal Propensity to consume (MPS):It may be defined as the ratio of change in saving dut to change in income.

MPC=∆S/∆YResult 1: Prove that APC+APS =1 or APS= 1-APCProof: consider Y= C+S

Divide both sides by Y(Y/Y)=(C+S) / Y1= (C/Y)+ (S/Y)1=APC+APS

Or APS=1-APS

Result 2: Prove that MPC+MPS=1 or MPS=1-MPCProof: consider Y=C+SAssume that increase in income be ∆Y.It is known that ∆Y= ∆C + ∆SDividing both sides by ∆Y, we get

∆Y/∆Y = (∆C + ∆S) /∆Y(∆Y/∆Y) = (∆C/∆Y) + (∆S/∆Y)1=MPC+MPS

Or MPS=1-MPCEx:

Income (Y)Consumption

(C )Saving: S=Y-

CAPC=C/Y APS=1-APC MPC=(∆C/∆Y)MPS=1-MPC

0 60 -60 - - - -

100 150 -50 1.50 -0.50 0.90 0.10

200 220 -20 1.10 -0.10 0.70 0.30

250 250 0 1.00 0.00 0.60 0.40

350 300 50 0.86 0.14 0.50 0.50

450 345 105 0.77 0.23 0.45 0.55

Consumption Function and Underdeveloped Economy:According to Keynes’s psychological law of consumption, an increment in consumption leads toless than proportionate increase in consumption so that MPC goes on declining, but MPS rises.It is possible to maintain a particular level of income in the advanced economy if all savingsare invested. However, situation is different in underdeveloped economies consumption functionpresents interesting features.People have unusually high average and marginal propensity to consume, therefore MPC is low,partly on account of low income levels and partly on account of high MPC. The MPC is not onlyhigh in underdeveloped countries but sometimes equal to one i.e. whatever increases take place inincome, the whole amount is spent on consumption because there is a lot of pent up desire, whichremains unfulfilled for want of purchasing power. As soon as income increases it is spent onconsumption. That is why, it is said that the shape of consumption function in such economies islinear (a straight line curve). The percentage of income saved decreases with increases in income,while the tendency is just the opposite in advanced economies.In advanced economies additional expenditure on consumption is primarily on industrialconsumer goods and the percentage of increased expenditure on food is very low. In an underdeveloped economy, on account of low level of income, increases in income tend to be mostlyspent on food grains and other protective food or in substituting superior quality of goods for aninferior type.In india, the income elasticity of demand for food has been found to be mostly near to unity.People in backward economies suffer from wrong consumption habits, on account of the effectsof conspicuous consumption and demonstration and interpersonal comparisons. They havedeveloped wrong consumption priorities. E.g. they seem to have entered the age of high massconsumption without attaining Rostow calls ‘take-off, or ,self-sustained growth’.

Again, in an under developed economy, house hold enterprise predominate and production ismore for self-consumption than for the market. Thus, whenincome increases, the demand for self-consumption increases and is met by a diversion of outputfrom market, causing a reduction in marketable surplus.However, there are few rich ‘islands’ in an under developed economy which enjoy high incomes,and high propensity to save. But their savings are frittered away on import o luxuries andconspicuous consumption.Break Even Point:It can be defined as the point where consumption and income are same.

i.e. C = YProblems:

1. The consumption function for an economy is given asC=400+0.68Y

i. Construct Consumption Scheduleii. Find Break Even Point (BEP)

iii. Calculate APS and APC at BEPSol:

i. Consumption Schedule:Let the income values are Rs 1000, Rs 2000, Rs 4000, Rs 6000, Rs 7000. By substituting theincome values in the given consumption function the corresponding consumption values will beobtained.

Y C=400+0.68Y

1000 400+0.68(1000)=1080

2000 400+0.68(2000)=1360

4000 400+0.68(4000)=2720

6000 400+0.68(6000)=4080

7000 400+0.68(7000)=4760

ii. Break Even Point:Breakeven point is a point where consumption is equal to income.

Y=CY=400+0.68YY-0.68Y=400

0.32Y=400Y=400/0.32Y= 1250

iii. Calculation of APC and APS:At BEP C=Y=1250By definition APC=C/Y

=1250/1250=1

We know that APS=1-APC=1-1=0

Conclusion:i. Consumption Schedule is shown in above

ii. Break Even Point : (C,Y) = (1250,1250)iii. At BEP APC=1 and APS=0

2. In a closed economy the consumption function is as followsC=250+ 0.8 YComplete the flowing table with given information.Y C APC APS MPC MPS5001000200025004000Represent the results graphically

Sol: Given the consumption function asC=250+ 0.8 YBy substituting the given values of income the corresponding consumption values will beobtained.Y C APC APS MPC MPS5001000200025004000

6501050185022503450

1.301.050.9250.90.8625

-0.30-0.050.0750.100.1375

-0.80.80.80.8

-0.20.20.20.2

Graph:

3. Given the consumption function C=280+ 0.6Yi. Define the above function

ii. Represent the function graphicallyiii. At what level of Y do households begin to saveiv. What will be the effect on aggregate consumption (C ) if income (Y) increased by Rs.300

after BEPSol:

i. Given the consumption function C=280+ 0.6YFrom the given relationship it is clear that C is an increasing function of Y where C isconsumption expenditure and Y is Income.280 is autonomous consumption expenditure, and 0.60 is marginal Propensity to Consume.

MPC= ∆C/∆Y= 0.60

=60/100It means that for every Rs 100 increase in income there will be Rs 60 increase inconsumption expenditure.

ii. Graphical Representation:C

C=YC=280+ 0.6Y

700

280

0 700 Y

iii. People begin to save after the BEP. So we have to calculate BEP.BEP is definedas the point where Income is equal to consumption.

Y=CY=280+0.6Y

Y-0.6Y=2800.4Y=280

Y=700

At BEP consumption and Income are equal. So people will start saving after BEP. It meanspeople start saving if their income is more than Rs. 700.

iv. It is given that income increased by Rs. 300 after BEPAt BEP income Y1= Rs 700 and C1=Rs. 700Increase in Income ∆Y=300New income Y2= Y1+∆Y

=700+300=1000

Now consumption expenditure after increase in income C2=280+ 0.6(1000)

=280+ 600= 880

So with the increase in income from Rs. 700 to Rs 1000 consumption expenditure is increased by180 i.e. from 700 to Rs 880.

Prof. P.Naresh Kumar, SIBER, Kolhapur