Theory of Consumption

Consumption is that part of income which is spent on purchase of consumer goods. The part of income that is not spent on consumption forms savings.

Consumption Function shows the functional relationship between consumption and the variables on which it depends. Other things being equal, consumption depends upon the level of income. Thus , consumption function is expressed as C = f(y).

Consumption schedule  is a table that shows consumption expenditure corresponding to various income levels.

Consumption curve is a geometrical presentation of the consumption-income relationship. It shows different levels of consumption (measured on Y-axis ) corresponding to different income levels (measured on X-axis) in a diagram.

Keynes's Psychological Law of Consumption has three interrelated proposition, viz.,

• when income increases, consumption expenditure also increases but generally increase in consumption expenditure is less than increase in income.
• When income increase, a part of additional income is used for consumption while the other part is saved.
• With increase in income, both spending and saving will go up and an increase in income is unlikely to reduce the level of consumption and saving from their earlier position.
  

These three interrelated propositions form the basis of concept of average and marginal propensity to consume.

Propensity to consume is the relationship between consumption and income as expressed by the consumption function C = f(y).

Average Propensity to Consume (APC) is the ratio of total expenditure to the level of income and is shown as APC = C/Y

Marginal Propensity to Consume (MPC) is the ratio of change in consumption to change in income and is expressed as MPC = ΔC/ΔY.

Slope of the consumption curve is defined by the MPC. When MPC is constant, consumption curve is straight line. A higher MPC means steeper slope or consumption line while a lower MPC means smaller slope or less steeper line. A continuously declining MPC will make the consumption curve successively less steeper as it rises upwards.

Income, consumption and saving relationship: At that level of income, where consumption curve intersects the 45o line, C = Y and hence there are no savings. Below that income, C > Y and therefore savings are negative. And above that intersection point Y > C and hence saving are positive. The gap between income and consumption line measure these negative and positive savings. The savings curve moves from the -Y axis to the +Y axis and its point of intersection with the X-axis income level with zero savings.

The straight line consumption function is defined by the equation C = a + bY where ‘a’ is the autonomous consumption, ‘b’ is the MPC and Y is the level of Income. In terms of diagram, ‘a’ is the intercept formed by the consumption line on the Y-axis and consumption expenditure at zero level of income.