Measures to Raise the Propensity to Consume

Measures to Raise the Propensity to Consume

            In the short period due to psychological and institutional factors, it is very difficult to stimulate consumption function which possible in long-run measures to raise propensity to consume in long run are as follows:

1.   Income Redistribution:

            Propensity to consume of poor people is higher than propensity to consume of rich people. Therefore, redistribution of income helps to raise propensity to consume if redistribution of income favours poor. Thus, propensity to consume can be raised transferring income from the rich to poor.

2.   Social security:

            Various type of social security measures raise propensity to consume in long run. For example provision for unemployment compensation, old age allowance, widow allowance, etc., remove uncertainties in future. Therefore, tendency to save is reduced and people start to consume more.

(3)  Wage policy:

            Wage rates are considered measure to raise consumption in both short-run and long-run point of view. But in short run, labour productivity can't be increased more will harm the labours more than benefit because increased wages will increase cost which may lead to unemployment. Thus in long-run, if wage rate and productivity of labour both are increased in same way then it will tend to raise level of consumption in economy.

(4)  Easy credit facilities:

            Consumption function shifts upward by the help of cheap and easy credit facilities.

(5)  Advertisement and publicity:

            In modern time, advertisement and publicity, propaganda and salesmanship are effective tools to attract consumers towards commodities because these make the consumers familiar with use of product. It raises consumption function of people.

(6)  Development of infrastructures:

            Development of infrastructures like transport, communication, hydropower, etc., helps to shift consumption function upward.

(7)  Urbanization:

            In urban areas people are highly influenced by the demonstration effect. This shifts the consumption function upward.

Determinants of Consumption Function Determinants of Consumption - Function Subjective Features & Objective Factors Demonstration motives Security motives Business motives Improvement and Development motive Income Distribution of income Windfall Gains or Losses Fiscal Policy

Determinants of Consumption Function

            The factors which determine the level of consumption is called determinants of consumption. J.M. Keynes mentions two principal factors which influence the consumption function and determine its nature (slope) and position. They are: subjective factors, and objective factors.

1.   Subjective Features:

            The subjective factors affecting propensity to consume consists of those psychological motives. Therefore, subjective factors are also known as psychological factors because these are internal factors that determine the consumption function. These factors are related to human behaviour and habits, social customs and traditions. There are different motives of consumers, which lead to determine the level of consumption.

(i)   Demonstration motives:

            If consumers are influenced by the consumption of other people and try to adopt similar consumption practices, such practices are known as demonstration effect. If the people of a country are affected by the demonstration effect, then the propensity to consume will be high and if not affected by the demonstration effect, then the propensity to consume will be low. Advertisement, fashion, luxurious life style, etc. are able to influence consumption pattern of the people.

(ii)  Security motives:

            The families and individuals in the modern industrialised societies are highly conscious with old age, sickness and other unforeseen contingencies related to economic insecurity. Hence, people try to save quite regularly. Such savings reduce the consumption function.

(iii)            Business motives:

            Business motive is one of the most important factors determining consumption function. Due to business motives the individuals and government cut down their current consumption. The business motive mainly influences the propensity to save of corporations and various business units. The uncertainty regarding the future, the quantity and quality of existing equipments, and other conditions give rise to motive for withholding a part of current earning which, in turn, reduces the consumption function.

(iv) Improvement and Development motive:

            Improvement and development motives of the country and individuals also influence the pattern of consumption function. If the people would like to develop and improve their life and society, then they are ready to sacrifice a part of their present consumption. Therefore, improvement motive is one of effective factors to determine consumption function.

2.   Objective Factors:

            Important objective factors which cause changes in the nature, shape and position of consumption are as follows:

(i)   Income:

            Income is the most important factor that determines a community's propensity to consume. As its income rises or falls, consumption also rises and falls.

(ii)  Distribution of income:

            Another factor determining how much will be spent for consumption out of a given income of the community is the way in which income is distributed. There is great inequality in the distribution of income in the modern capitalist societies with the result that the rich find it easy to save. This widespread inequality of income lowers the overall propensity to consume as the rich have already fulfilled most of their basic wants. A more equal distribution of wealth will raise the propensity to consume.

(iii)            Fiscal Policy:

            The fiscal policy of government relating to taxation, expenditure and public debt have significant effects on the consumption function. The Government's fiscal policy resulting in highly progressive tax system brings about more equitable distribution of income which increases propensity to consume. On the other hand, a regressing tax structure will reduce total consumption in the economy.

(iv) Windfall Gains or Losses:

            Sudden and unexpected gains and losses in income affect consumption accordingly. If windfall gains increases unexpectedly, then consumption will also increases and if losses increases, then propensity to consume will decrease. In the late twenties, there were huge windfall gains on account of the boom conditions in the American economy and consumption function shifted upwards.

(v)  Changes in the rate of interest:

            Changes in the rate of interest may also alter the propensity to consume though the direction of change is not certain. If the rate of interest goes up, people will consume less and save more in order to gain from lending on the higher rate of interest. On the other hand, people may consume more and save less with a fall in the rate of interest. Further, a person who desires a fixed income in future is likely to save less at a higher rate of interest than at a lower rate of interest.

(vi) Financial policies of corporations:

            The policies of joint stock companies and corporations with respect to dividend payments and investment also affect consumption in various ways. If corporations and companies keep more reserves and distribute less of their profits as dividends, it will lower the disposable income with consumers. On the other hand, if more income is distributed in the form of dividends more will be spend on consumption.

Keynes' Psychological Law of Consumption

Keynes' Psychological Law of Consumption

            Keynes' psychological Law of Consumption is an important tool of economic analysis in Keynesian economics. Keynes propounded the fundamental psychological law of consumption which forms the basis of the consumption function. The law implies that there is a tendency on the part of the people to spend on consumption less than the full increment of income. Therefore, this law is called fundamental law of consumption or psychological law of consumption. In other words, the law states that aggregate consumption is a function of aggregate disposable income. According to Keynes, consumption function shows the functional relationship between income and consumption. It explains the nature of propensity to consume. According to this law, people have a tendency to spend more on consumption when their income increases, but consumption expenditure won't increase by same extent as increase in income, because a part of increased income is saved. This law states that, "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". The psychology of the community is determined by people's habit, custom and tradition. This law way popularly known as 'propensity to consume' and subsequent writers called it 'consumption function'.

            Keynes' psychological law of consumption depends upon three related propositions:

(i)   When the aggregate income increases, consumption expenditure will also increase by a somewhat smaller amount;

(ii)  An increment of income will be divided in some ratio between saving and spending;

(iii) An increase in income is unlikely to lead either to less spending or less saving than before.

            Above given all the propositions of this law means that consumption essentially depends upon income and that income receivers always have a tendency to spend less on consumption than the increment in income.

Assumptions

Keynesian psychological law of consumption is based on the following assumptions:

(i)   Short-period: This law is related to the short-run because in the short-run distribution of income, price level, population growth, fashion, tastes, behaviour, etc., won't change. Consumption will only depend upon income.

(ii)  Normal Situation: There should be a normal situation in the economy for the application of this law. In such a situation, war, revolution, hyperinflation, etc., should not be occur.

(iii)      Laissez-faire Capitalistic Economy: It assumes the existence of a laissez-faire capitalistic economy. It means, this law only operates in a developed capitalistic economy where there is not any kind of government interference. That is, this law won't be applicable if government intervention occurs.

            The main proposition of Keynesian psychological law of consumption can be illustrated by the following hypothetical consumption schedule:

Schedule of Consumption and Income

[Rs. in Crores]

Income (Y)	Consumption (C) C=f(y)	Saving (S) S=Y-C
100	70	30
120	80	40
140	90	50
160	100	60
180	105	75
200	110	90

            In above table, when income increases, the consumption also increases but less than income. When income increases from Rs. 100 crores to Rs. 120 crores, then consumption expenditure also increases from Rs. 70 crores to Rs. 80 crores. It means that income in creased by Rs. 20 crores but consumption increased by Rs. 10 crores only, because of some part of increased income is saved.

Diagrammatically presentation of the law

            In the figure, when income increases from OY_0­ to OY₁, Consumption also increases from EY₀ to C₁Y₁, but the increase in consumption is less than the increase in income, i.e., C₁Y₁<CY. Similarly, when income increases from OY₁ to OY₂, consumption also increases from C₁Y₁ to C₂Y₂ and increased saving A₂C₂>A₁C₁.

            Thus, Keynesian psychological law of consumption explains about the psychology of community towards expenditure pattern that the consumption function measures not only the amount spent on consumption but also the amount saved.

Average Propensity to Consume and Marginal Propensity to Consume

Average and Marginal Propensity to Consume

            The consumption function has two technical properties, i.e., average propensity to consume (APC) and marginal propensity to consume (MPC), which are separately discussed below:

1.   Average Propensity to Consume (APC):

            Average propensity to consume is the ratio of aggregate consumption expenditure to aggregate income. It is found by dividing consumption expenditure by income. Therefore, ratio of consumption to income is known as average propensity to consume. Thus, the relationship between gross national income and aggregate consumption expenditure is the average propensity to consume. Average Propensity to Consume is expressed as: APC = C/Y, where, C = Consumption expenditure and Y = Income level. APC shows the proportion or percentage of aggregate consumption to aggregate income. For example, when income is Rs. 100 crores and consumption expenditure is Rs. 60 crores. Then, APC = C/Y = = 0.6 or 60%. Thus, the value of APC for any income level may be found by dividing consumption expenditure by income.

            APC decreases as income increases because the proportion of income spent on consumption decreases. The remaining amount of total income after consumption expenditure is the saving. This can be calculated as follows:

Average propensity to save (APS) = 1–APC & APC = 1–APS

2.   Marginal propensity to consume (MPC):

            Marginal propensity to consume denotes the ratio of a small change in consumption as a result of a small change in income. In other words, it refers to the marginal increases in consumption (DC) as a result of marginal increases in income (DY) and is expressed as MPC = , where, D stands for small or marginal increase in consumption and income. Thus, marginal propensity to consume is obtained by dividing change in consumption by a change in income. MPC can also be obtained by subtracting MPS from 1, i.e., MPC = 1 – MPS, where, MPS = Marginal Propensity to save (MPS = 1– MPC).

            We can explain the concept of MPC with the help of a numerical example. Suppose, income increases from Rs. 100 crores to 120 crores, i.e., increment in income (DY) is Rs. 20 crores. Corresponding to this increase in income, consumption may increase from Rs. 60 crores to Rs. 70 crores, increment in consumption is Rs. 10 crores.

Hence, MPC = DC/DY or, MPC = 10/20 = 1/2 = 0.5 (less than unity)

            The complement of MPC is marginal propensity to save, MPS. It can be easily derived from MPC. We know that an increment in income DY will be divided between an increment in consumption DC and an increment in saving, DS. i.e.,

            DY = DC + DS

            Dividing both sides by DY, we get

            1 = +

or   MPC + MPS = 1

Therefore, MPS = 1 – MPC

            In the numerical case given above, MPC is or 0.5; therefore, MPS is (1 – ) = . Thus, if MPC is known, MPS can be easily known without any difficulty as the income of the community is divided between saving and consumption. If one is identified, the other can be easily derived.

            Marginal propensity to consume of people decreases as the aggregate income increases. Thus, MPC of poor people will be greater than the MPC to rich people. So, MPC will be greater than zero and less than one. I.e., MPC>0 and MPC<1 or, 0<MPC<1.

            Average propensity to consume and marginal propensity to consume can also be explained with held of table and diagram.

Average propensity to consume & marginal propensity to consume

(Rs in crores)

Disposable Income (Y)	Consumption (C)	APC =	MPC =
100	80	= 0.8	–
120	95	= 0.79	= 0.75
140	110	= 0.785	= 0.75
160	125	= 0.781	= 0.75
180	140	= 0.777	= 0.75
200	155	= 0.775	= 0.75
220	170	= 0.772	= 0.75

            In the above table, APC is decreasing with every increase in income, which indicates that as income increases, consumption also increases but a lesser rate, because some part of income is saved.

            Similarly, MPC is less than one but positive. It is because of increased whole income is not spent on consumption, a part of income is saved. In the table, with every change in income, consumption also changes. When the ratio of change in consumption and income is calculated in table which 0.75. It is positive but less than one.

            This feature of MPC is important aspect of Keynesian psychological law of consumption. Thus, it can be technically stated as 0<MPC<1.

Nature of APC and MPC both are explained in figure below;

            In the figure-(A), the average propensity to consume (APC) is measured at point P. The nature of consumption curve 'C' measures the value of APC, which is OC/OY. The flattering of the consumption curve (C) to the right shows every increase in income, APC declines.

            On the other hand, marginal propensity to consume (MPC) is measured by the slope of consumption curve (C). It is shown in figure-(B) by RS/PS, where RS is the change in consumption (DC) and PS is the change in income (DY) or C₁C₂/Y₁Y₂ = MPC.

            The concept of MPC is of utmost importance as it tells us how an increment in income will be divided between consumption and saving. In fact, the psychological law of consumption can be stated as that MPC is always less than one.

• Consumption Function - Classical Theory of Employment – Concept of Consumption Function

CONCEPT OF CONSUMPTION FUNCTION

            One of the important tools of the Keynesian Macroeconomics is the consumption function. Consumption function is simply a name for the general income-consumption relationship embodied in the Psychological law of Consumption given by Keynes. Keynesian general theory of employment is based on the consumption function. In economics, consumption means the amount spent on consumption at a given level of income. There is direct relationship between income and consumption. If income increases, the consumption also increases and vice-versa. The consumption function implies the whole of the schedule showing consumption expenditure at various level of income of the people. Thus, consumption function is also termed as 'Propensity to Consume'. In short, the propensity to consume shows how the consumption expenditure varies with the change in income. According to K.K. Kurihara- "The propensity to consume is a schedule of expenditure at various income level".

            In the Keynesian theory, we are concerned not with the consumption of an individual consumer but with the sum of total consumption spending by all the individuals. The consumption function or propensity to consume refers to income-consumption relationship. It is a "functional relationship between two aggregates, i.e., total consumption and gross national income". So, consumption is function of income. Because, the consumption changes with the change in income level. Thus, consumption depends upon the income level of the people. Symbolically, the consumption function is expressed as, C=f(Y), where, C is the consumption expenditure, Y is income and f is a function of (functional relationship)

            So, the functional relationship between income and consumption is the consumption function. The consumption expenditure increases as increase in income. But consumption expenditure does not increase proportionately to the increase in the income. Consumption expenditure increases less than the proportionate increases in income. It is because people want to save part of income. Therefore, propensity to consume decreases as income increases because consumption will be less in proportion in relation to income.

            The concept of consumption function can be explained by the help of psychological law of consumption developed by J.M. Keynor. According to this law people have a tendency to spend more on consumption when their income increases but not to same extent as income increase, because a part of income is saved. This can be illustrated as in the following table.

Schedule of Consumption

Rs. in Crores

Disposable Income (Y)	Consumption Expenditure (C)	Saving (S) S = Y–C
0	20	–20
60	70	–10
120	120	0
180	170	10
240	220	20
300	270	30
360	320	40

            In above consumption schedule, income increases at the some rate of Rs. 60 crores every time, but the consumption expenditure increases by only Rs. 50 crores every time. Therefore, when aggregate income increases, the aggregate consumption expenditure also increases. But, increase in consumption expenditure is less than proportionately increase in income, because some part of the increased income is saved.

            Despite, the increase in income by Rs. 60 Crores every time and consumption expenditure increases by only Rs. 50 crores every time, but saving increases from 0 to Rs. 10, 20, 30 and 40 crores respectively. So, it can be clearly seen from the consumption schedule that as income increases, the consumption and saving both increases simultaneously.

            The concept of consumption function can also be illustrated graphically as follows:

            In above given figure, consumption expenditure is presented along on OY–axis and level of income on OX–axis. The 45º line is joint curve showing the relation between income and consumption, which is started from origin. This 45° line shows the fact that income and consumption are equal to each other. That is, Y=C shows the fact that all the income of a consumer is used in consumption expenditure. AEC line represents tzhe consumption function. This line shows that as income increases the consumption expenditure also increases. But, this also shows that the consumption expenditure increases less proportionately as compared to increase in income. The line showing consumption function originates from the point A on OY–axis. This is because of consumption won't be zero even if the income decreases to zero. Although, level of income is zero, the basic necessities must be fulfilled.

            If income is less than the consumption, then this is fulfilled either by using the past savings or by taking loan. But, this gap between income and consumption decreases as the income increases. At OY level of income the consumption and income are equal to each other. In this situation, there will be neither any saving nor any defficiency. When income increases beyond this, the consumption will also increase, but not as fast as income increases because some part of the increased income will be saved. It can be expressed as:

            Y = C+S

Where, Y = Income Level

            C = Consumption Expenditure

            S = Saving

            Hence, consumption function measures not only the amount of income spent on consumption, but also the amount of income is saved.