CONSUMPTION

FUNCTION

KEY CONCEPTS TO NOTE

CONSUMPTION

INVESTMENT

SAVINGS

DETERMINANTS OF THE
THREE

WHAT IS CONSUMPTION?
Consumption, in economics, is the use of
goods
and services by households.
The purchase of goods and services by
use of
households is called consumption
expenditure.
Consumption differs from consumption
expenditure primarily because durable
goods, such as automobiles, generate
an expenditure mainly in the period
when they are purchased, but they
generate consumption services (for
example,
an automobile provides transportation
services)
until they are replaced or scrapped.

Every time you purchase food at the drive-thru

or pull out your debit or credit card or cash to
buy something, you are adding to
consumption.
Consumption is one of the biggest concepts in
economics and is extremely important because
it helps determine the growth and success of
the economy.
Businesses can open up and offer all kinds of
great products, but if we don't purchase or
consume their products, they won't stay in
business very long!

TYPES OF CONSUMPTION

Direct or Final consumption:

when the goods satisfy human
wants directly and immediately.
E.g. taking of meals, use of
furniture etc.

Indirect or Productive
consumption when the goods
are not meant for final
consumption but for
producing other goods which
will satisfy human wants, e.g.
use of fertilizer in agriculture
etc

WHY IS CONSUMPTION IMPORTANT?

Consider this:

WANT
(DESIRE)

EFFORT

SATISFACTION

More often than not, this satisfaction is derived from the act of
consumption.
From the large scale perspective, in a country, say Philippines, the
consumption of any good can be directly related to the satisfaction
of wants.
This, in turn sets up demand. Demand induces supply and the cycle
goes on.
Household consumption decision is closely linked to saving decision.
(For given level of disposable income, deciding how much
to consume =
deciding how much to save!)

Theories in
consumption
8

Theories in consumption
Keynesian theory:
One of the most popular and well-known
theories is the Keynesian theory (offered by
John Maynard Keynes). This theory states
that current real income is the most
important determinant of consumption in the
short run. Simply said, you spend according
to how much income you have coming in.
This is the basis for most consumption
theory.
9

Theories in consumption
The term 'real' that is used in describing income
refers to how your income is affected by inflation,
or the natural rise in prices of goods and services.
So to elaborate, if your income went up 5% in a
year, but the price of goods or inflation went up 5%
also, your real income remained flat. You can't
really buy or consume any more goods than you
could before.

10

THE CONSUMPTION FUNCTION

Factors Affecting Consumption

1. Income :
2. Prices
3. Taxes
4. Income
5. Saving

6. Tastes and Preferences :

Rural and Urban Areas
7. Population : High Propensity
to consume because of limited
income
8. Innovation and Promotion
9. Engels Law and
Compositional Change in
Consumption Expenditure ; As
the family income level rose,
the proportion to toal income
of essential items like food
increased, while non-essential
items like recreation increases

12

The consumption function, as the name suggests

has to be dependent on a certain variable.

From a macro economic point of view, this variable is

National Income.
So, national consumption depends on National
Income.

A general consumption function:

C = f(Y).

THE MATH

C = a + b*Y

a = subsistence or minimal level of

Consumption
b=marginal propensity to consume
(MPC)
Y= income
And, C= total consumption expenditure

MPC

The proportion of an aggregate raise in pay that a

consumer spends on the consumption of goods and
services, as opposed to saving it.
Marginal Propensity to Consume is present in Keynes'
consumption theory and determines by what amount
consumption will change in response to a change in
income.

Suppose an employee receives a P.500/- bonus in addition

to the annual earnings. They now have P.500/- more in income
than they did before. If they decide to spend P.400/- of this
marginal increase in income and save the remaining P.100/-,
the marginal propensity to consume will be 0.8 (P.400/divided by P.500/-).

So, MPC= C/Y , where C and Y have their usual meanings.

MPS
The MPS is also known as the Marginal Propensity to
Save.
It is defined as:
1-MPC=MPS

In this graphical illustration of the consumption function,

a= 5,000
MPC= 3/4

SHIFTS IN THE CONSUMPTION CURVE

POSITIVE SHIFT:
Increase in Real
Assets and money
holding
Increase in
expectation of future
prices.

NEGATIVE SHIFT:
Increase in interest
rates
Increase in taxes

POSITIVE SHIFT

NEGATIVE SHIFT

SOME EXAMPLES

a= 100, b= 0.8, Y= P. 400

Then, using the formula:

C= 100+ 0.8*400
= 100+320
= 420

a= 175, b=0.75

Now, the function becomes:

C= 175+ 0.75*Y
For a given value of income, we can calculate the consumption
expenditure.

In some cases, the function is represented as:

C= a+b(Y-T)

Here, T represents taxes that are subtracted from the

income.

THE INVESTMENT FUNCTION

WHAT IS INVESTMENT?

Investment is the expenditure on capital goods

made for the purpose of income regeneration.

In other words, an investment is the purchase of

goods that is not used today but is used in the future
to create wealth or income.

The building of a factory used to produce goods and

the investment one makes by going to college or
university are both examples of investments in the
economic sense.

INVESTMENT

AUTONOMOUS

INDUCED

AUTONOMOUS INVESTMENT
Expenditure made that is independent of
economic growth. They are investments made
for the good of society and not for the goal of
making profits

For example: The Government invests on

infrastructure items, such as roads and highways,
and other investments that keep the economic
engine running.

It is shown that autonomous investment curve la is a horizontal straight line.

For example, when national income is 0Y1, the autonomous investment is
Rs. 10 billion. If national income increases to 0Y2, the autonomous
investment remains Rs. 10 billion and so on.

INDUCED INVESTMENT
Investment

which changes with the changes in

the income level, is called as Induced
Investment.

Induced Investment is positively related to the income

level. That is, at high levels of income entrepreneurs are
induced to invest more and vice-versa. At a high level of
income, Consumption expenditure increases this leads to
an increase in investment of capital goods, in order to
produce more consumer goods.

It is shown that the investment curve is positively

sloped. It indicates that as the level of national income
rises from 0Y1 to 0Y2, the level of induced
investment also rises from 011 to 012

AN EXAMPLE

The owner of a pizza chain decides to purchase a new

Rs.10,000 pizza oven, paying for it by taking Rs.10,000
out of the savings account at the 87th National Bank.
This is an example of investment because the oven
purchased will further generate income for the owner.

Investment Function
3000

2500

Investment in Rs.

2000

1500

Induced Investment
Autonomous Investment

1000

500

0
1

Income Rs. Thousand

10

SAVINGS

Definition

Savings are the amount left over when the cost of a

person's consumer expenditure is subtracted from the
amount of disposable income that he or she earns in a
given period of time.

WHAT IS SAVINGS?
To

economists, saving means not consuming

from a fixed amount of resources to enable
higher consumption in the future.

It is the decision to defer consumption and to

store this deferred consumption in some
form of asset.

PURCHASE
OF
SECURITIES

SAVINGS

INCREASE
IN BANK
DEPOSITS

INCREASED
CASH
HOLDINGS

The extent to which consumers save is

affected by their preference for the
future over present consumption,
expectations of future income and
rate of interest.

WHY DO PEOPLE SAVE?

People saveaccumulate assetsto finance their

retirement, and they dissavespend their assetsduring
retirement.

The more young savers there are relative to old

dissavers, the greater will be a nations saving rate.

The precautionary motivethat is, the motive to save in

order to be prepared for various future risksis one of
the key reasons people save.

By saving we can invest money to produce fixed capital,

which contributes to economic growth.

However,

savings do not always correspond to increased

investment. If the money is not deposited into a
financial intermediary, it is not recycled in investment.

This can cause a shortfall of demand and recession

instead of economic growth.

CASE STUDY #1

We said that Savings affect the workings of an economy?

The question is How?

Germany, in common with the rest of continental Europe,
has been suffering from a lack of demand, caused in
part by the Germans' high propensity to save. Other
European members, subject to similar macro economic
constraints, have done far better.
This is has led to a total lack of consumer confidence on
the part of the Government.

SOME THEORIES

THEORIES OF CONSUMPTION

ABSOLUTE THEORY
OF CONSUMPTION

LIFE CYCLE THEORY

RELATIVE
CONSUMPTION
THEORY

ABSOLUTE THEORY OF
CONSUMPTION
It is also known as the Absolute Income Hypothesis.
The Absolute Income Hypothesis is theory of consumption
proposed by English economist John Keynes.
This theory states that real consumption is a function of real
disposable income, total income net of taxes. As income rises, the
theory asserts, consumption will also rise but not necessarily at the
same rate.
While this theory has success modeling consumption in the short
term, attempts to apply this model over a longer time frame have
proven less successful.

RELATIVE CONSUMPTION
THEORY
This theory was developed by James Duesenberry.
It states that an individuals attitude to consumption
and saving is not solely dependent on income. Hence,
the percentage of income consumed by an individual
depends on his position in the income distribution
demographic.

THE LIFE CYCLE THEORY

This hypothesis addresses individual consumption

patterns

The life-cycle hypothesis implies that individuals both

plan their consumption and savings behaviour over the
long-term and intend to even out their consumption in
the best possible manner over their entire lifetimes

The key assumption is that all individuals choose to

maintain stable lifestyles. This implies that they usually
don't save up a lot in one period to spend furiously in
the next period, but keep their consumption levels
approximately the same in every period.

THE LIDUIDITY PREFERENCE

THEORY OF INVESTMENT

In the liquidity preference theory, Keynes said that people

value money for both "the transaction of current business
and its use as a store of wealth." Thus, they will sacrifice
the ability to earn interest on money that they want to
spend in the present, and that they want to have it on
hand as a precaution. On the other hand, when interest
rates increase, they become willing to hold less money
for these purposes in order to secure a profit.

Or, in other words:

The rate of interest is determined by the matching of demand and
supply of liquidity

According to Keynes, the demand for liquidity is

a result of three motives:

The Transaction Motive: people prefer to have liquidity to assure

basic transactions, for their income is not constantly available. The
amount of liquidity demanded is determined by the level of income: the
higher the income, the more money demanded for carrying out increased
spending.
The Precautionary Motive: people prefer to have liquidity in the
case of social unexpected problems that need unusual costs. The
amount of money demanded for this purpose increases as income
increases.
Speculative Motive: People retain liquidity to speculate that bond
prices will fall. When the interest rate decreases people demand more
money to hold until the interest rate increases, which would drive
down the price of an existing bond to keep its yield in line with the
interest rate. Thus, the lower the interest rate, the more money
demanded (and vice versa).

NET PRESENT VALUE (NPV)

The difference between the present value of cash inflows

and the present value of cash outflows. NPV is used in
capital budgeting to analyze the profitability of an
investment or project.
If the present values of all future cash inflows is greater than the
present value off all future cash outflows, NPV is positive.

If the opposite is true, then the NPV is negative.

RATE OF DISCOUNT: An approach to choosing the discount

rate factor is to decide the rate which the capital needed
for the project could return if invested in an alternative
venture. If, for example, the capital required for Project A
can earn 5% elsewhere, use this discount rate in the NPV
calculation to allow a direct comparison to be made
between Project A.

INVESTMENT

INTIAL
INVESTMENT

FUTURE CASH
INFLOW

RATE OF
DISCOUNT

FACTORS DETERMINING
CONSUMPTION

SUBJECTIVE FACTORS

OBJECTIVE FACTORS

1. Human nature

1. Level of income

2. Distribution of wealth
3. Expectations in change in price
4. Change in rat of interest

5. Changes in Fiscal Policy

6. Availability of goods
7. Attitude towards saving

FACTORS
DETERMINING
INVESTMENT

The two primary factors that influence economic

investment are:

Income: An increase in income encourages higher

investment from both firms and individual
consumers.

Interest Rates: However, a high interest rate can

discourage investment because high interest rates
make it more expensive to borrow money. To
encourage investment, interest rates need to be
lower.

Because all investments come with a certain amount

of risk, the interest rate represents an
opportunity cost. Even when a firm uses its own
funds on an investment, there is an opportunity
cost of using the funds for investment, instead of
lending out the money for interest. The level of
risk can be seen to a certain extent when
analyzing the income and interest rates, which
allows the risks to be managed

INVESTMENT AND INCOME

INVESTMENT AND INTEREST RATE

DETERMINANTS OF
SAVINGS

There are a number of determinants of saving. These

determinants are the major forces that shape the economic
scenario of a country. At the same time, determinants of saving
are also responsible for the development or downfall of the
investment sector of a country.

The major determinants are:

Income level
Production level
Consumerism

The price difference between the domestic goods and the

foreign goods also influences the savings rate

Some financial decisions of the public sector also play

an important role as the determinants of savings.
The percentages of children and old people are
also among the determinants of savings. This
section of a country's population is not expected
to generate income. Because of this, the portion is
dependent on the remaining part of the population
for maintaining their livelihood. All these factors
cause the saving capacity of the workforce to
come down to a certain level.

CASE STUDY #2

A COMPARATIVE STUDY IN
CONSUMPTION FUNCTION IN
IRAN AND INDIA

ABSTRACT

India and Iran are two of the oldest countries in Asia

and both are the transition countries in the world.

Both countries have had several Five-Year Plans to

increasing the real per capita income, growth rate of
GDP etc.

Both countries demonstrate similar problems like high

unemployment rate (especially for educated people),
poverty, high growth rate of population etc.

THE MAIN OBJECTIVE

The main objectives in this study are estimation of
Marginal Propensity to Consume (MPC) out of income
and wealth for both countries and then compare them
based on economics aspects. Another objective is to
show that which one of them is potentially going to
increase saving and Investment in the future.

INDIA
GROWTH RATE

IRAN

8%

3.9%

2908

410

3.7

2.6

(%)

GDP
(BILLION $)
PER CAPITA GDP
GROWTH
(%)

INDIA

IRAN

MPC OUT OF
WEALTH

0.221

0.189

MPC OUT OF
INCOME

0.672

0.541

0.8
0.7
0.6
0.5
0.4

India
Iran

0.3
0.2

0.1
0

MPC out of wealth

MPC out of income

CONCLUSION
This study has demonstrated the Marginal Propensity to Consume
of India is higher than that of Iran.
It has also revealed that not only MPC out of Income of India is
higher than Irans but also MPC out of wealth of India is more than
Irans.

This means that higher the MPC, greater the spending and
lesser the saving.
Hence, greater the demand!

Thats all folks!