UNIT - 11

CONSUMPTION FUNCTION & INVESTMENT FUNCTION

CONSUMPTION FUNCTION

Consumption refers to a particular amount of consumption out of a given amount of income.

Consumption function indicates the relationship between consumption and income.

Consumption function refers to different amounts of consumption at different level of income.

C = f (Y)

PSYCHOLOGICAL LAW OF CONSUMPTION

According to the law, “when aggregate income increases, consumption expenditure shall also increase but by a somewhat smaller amount.”

THE AVERAGE PROPENSITY TO CONSUME

TOTAL CONSUMPTION

APC =

TOTAL INCOME

THE MARGINAL PROPENSITY TO CONSUME

It is the incremental change in consumption as a result of a given increment in income.

It is the ratio of the change in aggregate consumption to the change in the level of aggregate income.

CHARACTERISTICS OF MPC :

Value is always positive but less than 1.

MPC is greater than 0.

It goes down as income increases.

MPC of the poor is greater than that of the rich.

RELATIONSHIP BETWEEN MPC & APC

INCOME CONSUMPTION APC MPC

100 100 100% -

200 180 90% 80%

300 240 80% 60%

400 280 70% 40%

500 300 60% 20%

INVESTMENT FUNCTION

Investment is the creation of income – earning assets.

TYPES OF INVESTMENTS:

Private Investment

Public Investment

Foreign Investment

Induced Investment

Autonomous Investment

SOME OTHER KINDS OF INVESTMENTS:

GROSS INVESTMENT

REPLACEMENT INVESTMENT

NET INVESTMENT

Ex – ANTE INVESTMENT

Ex – POST INVESTMENT

MARGINAL EFFICIENCY OF CAPITAL

It may be defined as the highest rate of return over cost accruing from an additional unit of capital asset.

Prospective yield from the capital assets.

Supply price (cost of capital assets) Q1 Q2 Q3 Qn

Cr = + + + ……………… +

(1+r) (1+r) (1+r) (1+r) 1 2 3 n

DETERMINANTS OF MEC :

SHORT – RUN FACTORS:

Cost & Price

Higher propensity to consume

Current rate of expectation

Changes in income

State of business confidence

LONG – RUN FACTORS:

Rate of growth of population

Development of new areas

Technological progress

Productive capacity of existing capital equipments

Rate of current investment

MULTIPLIER

It is defined as ratio of change in income to a change in investment.

Multiplier is a number which gives a multiple increase in national income due a given increase in investment, i.e. I

CHANGE IN INCOME

K =

CHANGE IN INVESTMENT

1

K =

1 - MPC

ASSUMPTIONS AND LIMITATIONS OF THE MULTIPLIER :

Availability of consumer goods.

Maintenance of Investments.

Net increase in Investments.

No change in the size of MPC.

No time gap between successive expenditure on consumption.

Existence of closed economy.

It is based on number of assumptions.

LEAKAGES :

Savings

Accumulation of idle cash balance.

Debt cancellations.

Purchase of old shares and stocks.

Imports.

Taxes.

Corporate savings.

ACCELERATOR

∆ I A = --------------------- ∆ C