In this article, you will learn about the concept of consumption function which is based on Keynes’ psychological law of consumption. In particular, you will learn the nature of the functional relationship between consumption and income or disposable income including the subjective and objective factors that influence the level of consumption.
You will also learn that, the concept of saving function is closely related to the concept of consumption function. In fact, the consumption and saving decisions are taken simultaneously. This is because all income which is not spent on consumer goods is defined as savings.
Also, what an individual spends on consumption, is not available for savings; and what he does not spend on consumer goods can only be saved or spent on investment goods. Income spent on investment is part of savings, as all savings will ultimately be invested. Thus, you will learn the concept of consumption function, and also of saving function.
Aggregate demand comprises three components; these are consumption, investment, and government expenditures. Consumption expenditure comprises expenditures incurred by the household; all these expenses are integrated into a consumption function.
Investment is also one of the components of aggregate demand, investment expenditure consists of all expenses incurred by the investing sector, and all these expenses are integrated into an investment function. The investment function includes a some interesting concepts related to Induced Investment, Autonomous Investment, Determinants of Investment, among others. Government expenditure refers to those expenses incurred by the government in the course of performing their role. In this unit, we discuss some of the concepts considered relevant to our level of study.
Definition of Consumption & Consumption Function
Consumption is defined as the total expenditure or spending by households on goods and services, which yields satisfaction in the current period. In macro-economic theory, consumption is defined as the spending by all the households in the economy, on goods and services produced within the economy.
Consumption function refers to any equation, table or graph which shows the relationship between consumers’ income or disposable income and m the amount they plan or desire to spend on currently produced final goods and services. Given that consumption can be related to national income (Y), the consumption function can be expressed as:
C = f(Y) ——- (1)
Where, C, is consumption, Y is income, and f is the functional relationship. In explicit equation form, equation (1) can be written as:
C = a + bY ——- (2)
Equation (2) takes into consideration the fact that some consumption expenditure can be attributed to unearned income such as gifts from friends, as well as transfer payments from the government or private business enterprises. Therefore, the letter ‘a’ in equations 2 represents the level of consumption which will occur independent of the level of income that is, the level of consumption when income is zero.
Thus, we refer to the letter ‘a’ as autonomous consumption, i.e. consumption expenditures when no income is earned. The letter b in equation (2) is the marginal propensity to consume or the slope of the consumption function. Letter ‘a’ and ‘b’ are assumed as constants. While a>0, 0<b<1. The fact that b>0 m means that increase in income is not all consumed but part of the amount of the increase in income is saved or spent on investment.
Determinants of Consumption
The determinants of consumption expenditure can be classified into objective and subjective factors. The subjective factors are psychological in nature and largely non-quantifiable. The objective determinants of consumption, on the other hand, are quantifiable.
Subjective Factors Determining Consumption: Keynes (1936) identifies six subjective determinants of consumption, which have since been refined and expanded. These factors include;
Enjoyment
Here, consumption is the result of the desire by a consumer to enjoy his life. Some people have a high taste and live Epicurean live. An individual may want to own a car, a television set, take a holiday abroad etc. In Nigeria, some people enjoy parties, take titles etc, which constitute consumption
Short-sightedness
People in paid employment tend to maintain a high level of consumption. They may disregard the fact that the job could be lost Such behaviour does not encourage saving. With some foresight, a consumer can devote some fraction of his current income to saving.
Generosity
Some people are by nature generous. They share whatever money they possess with others. Thus, the consumption purchasing they undertake does not only serve their personal needs but also those of beneficiaries of their donations.
Miscalculation
A consumer’s consumption expenditure could be predicated on the assurance that he will remain in paid employment for a long time. Such calculations do not encourage the individual to save as the perceived future income will cater for his needs. However, such calculations may turn out to be wrong. A sudden change in the business fortunes of the employer would result in job loss.
Ostentation
Apart from the foregoing factors, consumption purchasing is equally determined by ostentation. This category of consumption is undertaken by people who want to be noticed by the society. Posh cars, large houses and expensive clothes are some of the items of ostentation consumption. A person who prefers a Rolls Royce, BMW or Mercedes Benz 500 to a Peugeot 504 car in Nigeria can be said to be ostentatious since a Peugeot 504 can perform the function of a Rolls Royce.
Extravagance
Some individuals have a high propensity to spend. Extravagant people are in the habit of making purchases always, whether or not such items are useful. In short, such people are spend-thrift. While others refrain from spending and save as a habit, extravagant people spend excessively.
Objective Determinants of Consumption: the following are the objectives determinants of consumption:-
Changes in the Wage Level
Rise in the wage rate will shift the consumption function upward. A cut in the wage rate will shift the consumption function downward. A rise in wage rate that is accompanied by a more than proportionate rise in the price level will bring about fall in real wage rate and this will tend to shift the consumption function downward.
Windfall Gains or Losses
Windfall gains in the stock market will lead to upward shift in the consumption function whereas unexpected losses will lead to downward shift in the consumption function.
Change in Fiscal Policy
Changes in fiscal policy in the form of taxation and public expenditure affect the consumption function.
Changes in Expectation
For instance if prices are expected to fall in the future, people would buy only those things that are very essential. It will lead to a fall in consumption demand and a downward shift of the consumption function. The converse will be the case if prices are expected to rise in the future.
Changes in the Rate of Interest
A rise in the rate of interest will lead to a fall in the price of bonds, tending to discourage the propensity to consume by bond holders. It may also have the effect of substituting one type of assets for another.
In case they are buying durable consumer goods like refrigerators, scooters, etc on hire-purchase system they will tend to postpone their purchase when the rate of interest rises. They will have to pay more in installments and thus their consumption function will shift downwards.
Financial Policies of Corporations
Financial policies of corporations with regards to income retention, dividend payments and re-investments tend to affect the consumption function in several ways. For instance, if corporations keep more money in the form of reserves, dividend payments to shareholders will be less. This will have the effect of reducing the income of the shareholders and the consumption function will shift downwards. If corporation keeps lesser mount for same purpose, the reverse will be the case.
Personal Wealth
There is a positive relationship between the level and value of personal wealth and consumption purchases. If people hold large liquid assets they will have a tendency to spend more out of their current income and the propensity to consume will move upward, and vice versa.
Attitude Toward Saving
The consumption function is also influenced by people’s attitude toward saving. If they value future consumption more than present consumption, they will tend to save more and the consumption function will shift downward, and vice versa.
The Definition of Saving and Saving Function
Saving is the act of postponing current consumption. A process made possible by the excess of disposable income over consumption. It differs from savings that is a stock concept, referring to the money set aside.
The saving function shows the levels of personal savings that will take place at each level of disposable income.
Definition of Investment and Investment Function
Strictly defined, investment is expenditure on real capital goods. However, to the economist, investment takes place only when there is an actual net addition to capital goods. It should be noted that this definition covers ‘gross investment since it makes no allowance for the depreciation of existing capital assets. Note that Gross investment is total investment in an economy during a period of time.
Net investment is gross investment less depreciation (capital consumption or installmental provision for replacement). In the Keynesian tradition, investment is determined by factors that are exogenous to the income determination equation. Hence, investment is autonomous and designated as:
I lo, showing its fixity.
However, with the relaxation of the exogeneity assumption about investment purchasing, investment is considered as being determined within the income determination model and is influenced by such factors as the economy’s level of income (Y) and, or rate of interest (r) in addition to the autonomous component. The investment function therefore is a summary of the major variables that influence the levels of investment. Thus, for the economy, the investment demand can be written as:
1=f(Y,r); d1/dY>0, dr/dY<0. dl/dY> 0
implies that an increase in income will bring about an increase in investment, all things being equal. dl/dr< 0 implies that an increase in interest rate will bring about a decrease in investment, all things m being equal.
Major Determinants of Investment
• Uncertainty in the business environment, rumors, technological changes, and political developments;
• Existing capital stock such as large capital stock will discourage investment on capital goods;
• Level of income; Consumer demand; Population; and Taxation.
Summary
The concepts of consumption and consumption function, saving and saving function, investment and investment function were defined. Also defined are: the average propensity to consume, marginal propensity to consume, average propensity to save, marginal propensity to save, autonomous and induced investment. In the same study session, the determinants (subjective and objective determinants) of consumption were stated and explained. Finally, the determinants of investment were highlighted.