7. consumption function
TRANSCRIPT
Consumption Function Theory of consumption function explain relationship
between consumption & income As per J.M Keynes, consumption expenditure of
household depends mainly on their current income Other factors influence like interest rate, taxation,
amount of wealth etc. As per Keynes, when income increases, consumption
increases but in a lesser proportion due to savings factor Consumption Function is also known as Propensity to
consume
APC & MPC Consumption function can be explained through
Average Propensity to Consume (APC) and Marginal Propensity to Consume (MPC)
APC – ratio of total consumption expenditure to total income
APC = C / Y i.e. Consumption / Income For instance, C = 60,000, Y = 1,00,000 APC = 60000 / 1,00,000 = 0.6 or 60% Household spends 60% of its income on consumption
APC & MPC MPC – Ratio of change in consumption to
change in income MPC = C / Y i.e. Change in Consumption
/ Change in Income Instance, change in C = 60,000 to 1,00,000 &
Y = 1,00,000 to 2,00,000 MPC = 40,000 / 1,00,000 = 0.4 or 40%
APS & MPS Counterparts of APC & MPC are APS & MPS APS – Average Propensity to Save MPS – Marginal Propensity to Save APS = S / Y (S = Savings, Y = Income) MPS = S / Y (Change in Savings / Change in
Income) APC +APS = 1 and MPC + MPS = 1 Rich people have more of MPS compared to poor MPC will be greater than MPS
Y C APC (C/Y)APS (S/Y)(1 –
APC)
MPC( C/ Y)
MPS ( S/ Y)(1-MPC)
1000 1000 1 0 - -
2000 1800 1800/2000 = 0.9 0.1 800/1000
= 0.8 0.2
3000 2500 2500/3000 = 0.83 0.17 700/1000
= 0.7 0.3
4000 3000 3000/4000 = 0.75 0.25 500/1000
= 0.5 0.5
5000 3200 3200/5000 = 0.64 0.36 200/1000
= 0.2 0.8
Factors Determining Consumption Function
2 types of Factors Objective Factors Subjective Factors – help in more saving
rather than spending hence consumption is reduced
Objective Factors Size of Income Price Level Distribution of
Income Propensity to Save Future Expectations Taste & Fashion
Rate of Interest Sudden Gains or
Losses Ownership of Assets Corporate Policy
(Dividend) Fiscal Policy Other Factors (Loans)
Subjective Factors Precaution against illness, accident,
unemployment etc. Future Expectations & Needs Accumulation of Wealth Independence Investment Speculation
Effective Demand J.M. Keynes emphasises on high level of
effective demand to maintain high level of employment
Effective Dem = Consumption Dem + Investment Dem
Consumption Demand Demand for final goods & services Depends upon level of income & propensity to
spend In Short run, it remains stable
Effective Demand Investment Demand
Demand for Capital Goods Depends upon rate of interest and marginal
efficiency of capital In short run, rate of interest is stable Marginal Efficiency of Capital is influential factor in
determining level of investment demand In short run, consumption demand remains stable
hence, level of employment is influenced by investment demand
Marginal Efficiency of Capital (MEC)
MEC is the expected rate of profitability from a capital asset
Rate of Return expected over & above the cost of an additional unit of capital asset
Capital Asset is brand new asset & not existing one Similarly, “return” is expected returns & not
existing returns or actual returns MEC depend upon prospective yield from capital
asset & supply price of the asset
Marginal Efficiency of Capital (MEC)
Prospective Yield From Capital Asset
Supply Price of
Capital Asset Total net return expected
from asset over its lifetime Net income received by
selling its output (products manufactured by machinery)
Net Income = Gross Income – Cost
Price of asset is considered before purchasing
Comparison is made between supply price & yield from the asset
Investment is made when yield is more than supply price
MEC According Keynes, MEC is the rate at which prospective
yield from a new capital asset to be discounted to make it equal to the supply price of the asset
Supply Price = 10,000 , Prospective Yield = 15,000 MEC = Price gap between them Formula to equalize prospective yield to supply price Cr = Q1/(1+r)1 + Q2/(1+r)2 + Q3/(1+r)3 ...... Qn/(1+r)n Cr = Supply Price of asset, Q1, Q2 = annual returns from
capital asset, r = rate of discount (marginal efficiency of capital)
MEC To find out r, formula can be rearranged as r = Q1 - 1 Cr For Instance, Supply Price = 1000 crore, Prospective yield for
1st year = 1250 crore r or MEC = 1250 / 1000 -1 = 0.25 or 25% When MEC is known and Prospective yield is to be calculated Cr = Q1 1000 = Q1 = 1250 (1+r)1 1+0.25 MEC and Interest Rate is compared, if MEC > Interest rate,
then investment project will be undertaken
Investment Demand Curve MEC curve slopes
downwards from left to right indicating inverse relationship between Investment & MEC
When more investment is made, prospective yield will decline supply price will rise
Questions 1. Explain the concept of consumption function 2. Differentiate between APC & MPC, APS & MPS 3. Throw light on the factors influencing consumption
function (Subjective or objective can come as short Note) 4. Sums to Calculate APC, MPC, APS, MPS will come 5. Discuss the concept of Effective Demand 6. Throw light on the concept of MEC with suitable diagram 7. Explain Investment Demand Curve 8. Sums to calculate MEC, Cr, Q will come