Consumption Function

Consumption Function Example

The consumption function can be depicted through a schedule that shows the relationship between the various amounts of consumption expenditure for different amounts of income. This schedule can be plotted on a graph which then can be used to analyze the resulting outcomes or trends.

Figure 1. Aggregate Consumption Function, StudySmarter Originals

Figure 1. above shows the consumption function where aggregate current disposable income is found on the X-axis and aggregate consumption expenditure is found on the Y-axis. The slope of the line is MPC, i.e. when consumer income increases by $1, consumer expenditure increases by MPC. The formula for MPC is:

$MPC=\frac{∆C}{∆Y}$

In addition, the consumption function can be linear or non-linear. A linear consumption function would be as seen in Figure 1 above, where. MPC will remain to be a constant value between 0 and 1 through all levels of income. A non-linear consumption function will have a changing MPC through the different levels of income. Economists have theorized that as household income increases and the needs are satisfied, then the MPC will decline and MPS (marginal propensity to save) will be increasing as income increases. The resulting effect is a non-linear consumption function with a diminishing slope.

Figure 2. Aggregate Consumption Function, StudySmarter Originals

Figure 2 above shows a non-linear consumption function with a diminishing MPC.

Factors Affecting Consumption Function

Now that we have seen a consumption function, we can next examine what causes a consumption function to shift. Since a consumption function depicts the relationship between consumer income and consumer expenditure, ceteris paribus (holding other things constant), the shift in the consumption function results from changes in other factors other than consumer income.

There are two main factors that cause a shift in the consumption function; one being a change in expected future disposable income and the other a change in aggregate wealth.

Change in expected future disposable income

The permanent income hypothesis, theorized by Milton Friedman, states that the primary factor that consumer expenditure is dependent on is the expected future income rather than the income they currently hold. For example, suppose you are expected to receive a very large bonus from your employer, but the effective date for the bonus is not for another two months. Nonetheless, you start planning a new vacation or buying new things as you are anticipating an increase in your income in the near future. Similarly, if you were to receive the news that you will be receiving a pay cut in the coming months, you would cut back on your expenditure despite your current disposable income not experiencing any change.

Change in aggregate wealth

The life cycle hypothesis states that consumer expenditure is a byproduct of accumulated wealth, which results in expenditure spread over a lifetime and is not dependent on just current disposable income. In other words, households save their current disposable income in each period of high earnings and then use their accumulated wealth in the later years of their life to both spend and live off of. For example, your retired parents who each worked for 25 years in their respective fields have invested and saved their current disposable income over the years. They were also able to pay off their mortgage, and their current disposable income is $250,000. You may have the same current disposable income as them, however, their expenditure on goods and services will be more than yours, because you would still need to save for your retirement and pay off your mortgage.

Overall, the change in expected future disposable income and the change in aggregate wealth both have the same effect on the aggregate consumption function.

Figure 3 above shows an upward shift in the aggregate consumption function resulting from either an increase in expected future disposable income or from an increase in aggregate wealth.

Figure 4 - Aggregate Consumption Function with a Decrease in Consumer Income & Wealth, StudySmarter Originals

Figure 4 above shows a downward shift in the aggregate consumption function resulting from either a decrease in expected future disposable income or from a decrease in aggregate wealth.

Importance of Consumption Function

The consumption function is a great and important tool in understanding other macroeconomic indicators, variables, and factors. Through the analysis of the consumption function, we are able to better understand the business cycle, interest rates, capital stock, and money supply, just to name a few. The insights that the consumption function provides to decision-makers are key to formulating policies, making investments, and other macroeconomic decisions. You may be wondering how the consumption function does that? The consumption function provides insights into one of the greatest economic agents in any economy, the household and their decision-making and consumption behavior, which has a large impact on the economy.

Keynesian Consumption Function

The aggregate consumption function is also known as the "Keynesian Function", named after the founder John Maynard Keynes, a British economist who theorized that consumer expenditure is a function of disposable income. Prior to Keynes's revelation about the consumption function, economists theorized that consumption is a function of interest rates. Keynes's argument, on the other hand, was that consumption was a function of income, and interest could play some role but is not the sole driving factor. Given this, his theory is also known as the absolute income theory of consumption, in which he states an increase in income will result in an increase in consumption, however not by the same proportion. This is where the MPC, marginal propensity to consume, would come into play. The MPC, according to Keynes's theory, would be less than one.

The Keynesian consumption function is based on Keynes' beliefs about consumer behavior. Keynes states that consumption depends on the absolute income available in the given period. In other words, the more income a household has in a given period, the more likely it is to be spent on consumption. In addition, Keynes also emphasizes that the proportion of the increase in consumption does not equate to the proportion of the increase in income. The proportion of consumption to income is referred to as the average propensity to consume, or APC. It is calculated as consumption over disposable income.

$APC=\frac{C}{Y}$

Difference between APC & MPC

The average propensity to consume and marginal propensity to consume may sound similar, but tell us two completely different stories about the consumption function. The average propensity to consume, APC, tells us how much the economy is consuming at each given level of income, whereas the marginal propensity to consume is the slope of the aggregate consumption function and tells us the change in consumption to the change in income. It is calculated as:

$MPC=\frac{∆C}{∆Y}$

Figure 5. Aggregate Consumption Function with APC & MPC, StudySmarter Originals

In Figure 5 above, you can see that the slope of the consumption function, MPC, is less than the slope of the line from the origin to each point on the graph, which is the APC. Thus, with a nonlinear consumption function, both MPC and APC decline as aggregate current disposable income grows, and MPC is always less than APC at each level of disposable income.

Keynesian Multiplier

The Keynesian Multiplier is an economic concept which states that an increase in government expenditure, private investment expenditure, or private consumption expenditure will result in an increase in GDP greater than the total initial expenditure in the sectors mentioned above. However, he emphasized that the initial expenditure should be by the government, which will then be a catalyst for expenditure for the other sectors and agents in the economy.

The Keynesian multiplier is:

$Multiplier=\frac{1}{(1-MPC)}$

For example, if the MPC for a consumption function is 0.8, we can determine the multiplier by putting our MPC amount into the equation:

$Multiplier=\frac{1}{(1-0.8)}=5$

This says that, given an MPC of 0.8, the increase in GDP that results will be 5 times the increase in initial spending. So if the government, say, spends $1 trillion, the increase in GDP will be $5 trillion.