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Ba LLB economics notes pdf psychological Law of Consumption
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Q.3. State and explain Keynes Psychological Law of consumption.
*What are MPC and the APC and how do they differ?
*Compare linear and non-linear consumption functions.
*Explain the determinants of Propensity to consume.
Ans. Psychological Law of Consumption
The consumption function, the relationship between consumption and income, is largely a Keynesian contribution. Keynes postulated that consumption depends mainly on income. In regard to the relationship, he argued that consumption increases as income increases but by an amount less than the increase in income.
It is, however, assumed that by income Kcynės meant the disposable income of the consumer. Keynes designated tendency of consumption varying directly with disposable income as the “Fundamental Psychological Law”.
Açcording to this law, “men are disposed of, as a rule, and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income.”, This law is known as “Propensity to Consume’, or Consumption Function.
This law consists essentially of three related propositions:
(a) When aggregate income increases, consumption expenditures also increase but by a somewhat smaller amount. The reason is that as income increases, more and more of our wants get satisfied and, therefore, lesser and lesser amounts are spent out of subsequent increases in income.
(b) The second proposition is that when income increases, the increment of income will be divided in a certain proportion between consumption spending and saving. This follows from the first proposition because what is not spent is saved.
(c) The third proposition is that. as income increases, both consumer spending and saving will go up. An increment in income is unlikely to lead either to less saving or less spending than before. It Would seldom happen that a person decreases his consumption or his saving with an increase in his income. He would spend more than before and also save more than before.
Assumptions of the Law
Keynes’ Psychological Law of Consumption is based on the following three assumptions:
(a) It is assumed that the habits of people regarding spending do not change or that the propensity to consume remains the same.
Normally, the propensity to consume is more or less stable and does remain unchanged. This assumption implies that only income changes when other factors like income distribution, price movement, growth of population, etc., remain more or less constant. In the short run, these factors are constant or approximately so. In the long run, that may not be true. So the law holds true only in the short period.
(b) The second assumption is that the conditions are normal in the economic system. There is no state of war, revolution, hyperinflation or any other such abnormal condition. The law may not hold good under abnormal conditions.
(c) The third assumption is that of the existence of a capitalistic laissez-faire economy. The law may not hold good in an economy where the State interferes with consumption or productive enterprise. The government, for instance, may not permit an increase in consumption With the increase in income.
Explanation of the Law
Consumption (C) is, therefore, according to Keynesian analysis, a function of (determined by) income (Y). This relationship is often algebraically expressed as C = f (Y), where C stands for consumption, function and Y for income. Keynes has made use of four concepts analysing the consumption-in-come relationship. there are:
(1) Average PrOpensity to consume,
(2) Marginal propensity to consume,
(3) Average propensity to save, and
(4) Marginal propensity to save.
A. Average and Marginal Propensities to Consume
The relationship between income and consumption is measured by the average and the marginal propensities to consume. The average propensity to consume (APC) defincs the relationship between total income and total consumption. It is the ratio of total consumption to Total income. It can be computed for individuals or for all consumers, that is, on an individual or aggregate basis.
Symbolically : APC = C/Y
where C is aggregate consumption, and Y the aggregate income of the economy. Formally, we define the average propensity to consume as the ratio between total income and total consumption.
While the average propensity to consume is the ratio of totał consumption to total income, the marginal propensity to consume 1s the ratio of the change in total consumption to the change in total income. lf the change in consumption associated with the change in income is denoted as ∆C; and the change in income as Y, the ratio of the change in consumption to the change in income is called the marginal propensity to consume. Symbolically, MPC = ∆C/∆Y
B. Average and Marginal Propensities to Save
The average propensity to save (APS) is the ratio of total saving to total income.
Symbolically, APS = S/Y
APC + APS equal 1. Since income is either consumed or saved,
C +S = Y
then, C/Y+S/Y=Y/Y= 1
APC+ APS = 1
The APC and APS must add up to one at all income levels. While average, propensity to save (APS) is the ratio of total saving to total income, the marginal propensity to save. (MPS) is the ratio of the change in saving to the change in total income. If the change in saving associated with the change in income is denoted as ∆S, the change in income as ∆Y; the ratio of change in saving to the change in income ∆S/∆Y is called the marginal propensity to save.
Just as APS and APC add up to 1, in the same way MPC and MPS also add up to 1.
We know that Y = C +. S
Or ∆Y = ∆C+ ∆S
so ∆Y/∆Y = ∆C/∆Y + ∆S/∆Y
Thus, 1 = MPC + MPS
and 1 – MPC = MPS.
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Determinants of Propensity to Consume Income is the principal determinant of propensity to consume. A propensity to consume (or consumption function) is, however, determined by other factors as well. These are enumerated below. (i) Rate of Interest. The classical economists assumed that consumption was a function of the rate of interest. In particular, they believed that an increase in the interest rate encourages saving and discourages consumption. Later economists have been sceptical on both theoretical and empirical grounds. An increase in the interest rate may encourage saving thereby discouraging consumption. But it may also have the opposite effect. If an individual saves in order to have a fixed amount at retirement or at some other time, he will find that, at a higher rate of interest, he can save less of his current income and still reach his goal because, with a higher interest rate, is savings will earn a higher return and thus grow more. rapidly. Consequently, he can afford to consume more of his current income. If society is composed primarily of “target” savers, an increase in the rate of interest will reduce saving and increase consumption. This view is contrary to the view of the classical economists. In general, it is difficult to establish on the basis of pure theoretical reasoning what effect a change in the rate of interest will have on consumption. Even on an empirical basis, most studies have found that consumption is relatively insensitive to changes in the interest rate. (ii) Wealth. Wealth has also been regarded as the most important determinant of consumption. The larger the wealth possessed by a person, the lower would be its marginal utility to him and as such the weaker would be the desire to add to future wealth by reducing current consumption. Consumption, therefore, will be higher with more wealth. (iii) Liquid assets. These assets are defined as including such items as government securities, demand deposits, time deposits, currency, shares, etc. Liquid assets can be spent at any time because these assets can be readily converted into money. Such assets are for the consumers a potential source of purchasing power. and L.C. Chau has placed special emphasis on the accumulated stock. of consumer’s liquid assets as a determinant of consumption. They state that liquid assets are a barometer for many short-run factors that affect consumption. (iv) Capital gains. Capital gains (or losses) also have an impact on aggregate consumption. It is so because sudden and unexpected gains increase the individual’s net worth, and thereby losses would reduce consumption. On the contrary, sudden and unexpected losses would reduce consumption. The boom conditions during the late twenties in the U.S. economy created huge windfall gains which are believed to have raised the consumption spending. (v) Expectations.The consumption of a person is also influenced by expectations regarding future movements in income and prices. For instance, if an individual expects his income to be lower in the future he may refrain from making a purchase. today on two counts. First, because any indebtedness associated with the purchase will have to be paid back later out of his lower income. Second, because he may desire to save today in order to be able to continue consumption purchasing at the same level in the future when his income declines. On the other hand, if an individual expects a high level of income in the future, he may go into debt today in order to attain a high level of consumption because he feels that he not only can continue that level of consumption but also can pay back debts incurred at a result of today’s consumption out of his higher future income.(vi) Stock of Consumer Durables. The stock of durable consumers goods also influences the level of consumption. An individual’s stock of durable consumers goods has a dual effect on the possible level of his consumption expenditure. First, possession of these goods undoubtedly reduces his desire to use a portion of his actual income (or current income) to make an additional purchase since he already has them. For instance, a family which possesses a refrigerator may not go in for another one. On the other hand, the possession of such durables may encourage them to purchase commodities of non-durable nature, for example, the stock of fruits, vegetables, milk, eggs, etc., more than what is needed to keep the refrigerator in full use. This causes an upward. a shift in the consumption function. (vii) Consumer Credit. Availability of credit to consumers on easy terms is an important factor influencing consumer purchases of durables. M.K. Evans has found that the use of instalment consumer credit raises the aggregate demand in the economy both in the short and long period. Instalment credit increases aggregate demand because the replacement of durable consumer goods rises .and because instalment purchasing, partly, takes place at the expense of saving. Though credit purchase entails some cost, namely, interest payment, the consumers do not pay attention to it and spend more on consumption. Thus, consumer credit ànd credit purchases influence the level of consumption. (viii) Distribution of Income. Consumption is also influenced by the pattern of the income distribution. The propensity to consume varies from one income group to another. It is normally higher for low-income groups than those of high-income groups. This is because the poor have a lot of unsatisfied wants and are likely to spend every additional unit of money that they obtain in satisfying those wants. In contrast, the rich have a high standard of living and relatively less urgent wants remain to be satisfied. Additional income in their case, therefore, is more likely to be saved than spent on consumption. Hence, given the total income, a more equal distribution of income will cause an upward shift in the consumption function. (ix) Taxation Policy. Taxation measures of the government may influence the average propensity to consume and bring about shifts in the Consumption function. An increase in direct taxes will reduce disposable income at all levels of income.
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