Consumption Function Definition

consumption-function

The Keynesian Consumption function expresses the level of consumer spending depending on three items

  • Yd – disposable income
  • a – autonomous consumption (consumption when income is 0. (e.g. even with no income, you may borrow to be able to buy food))
  • c – marginal propensity to consume (the % of extra income that is spent) Also known as induced consumption.

Consumption Function formula

  • C = a + c Yd

This suggests Consumption is primarily determined by the level of disposable income (Yd). Higher Yd, leads to higher consumer spending.

    This model suggests that as income rises, consumer spending will rise. However, spending will increase at a lower rate than income.

    • At low incomes, people will spend a high proportion of their income. The average propensity to consume could be one or greater than one. This means people spend everything they have. When you have low income, you don’t have the luxury of being able to save. You need to spend everything you have on essentials.
    • However, as incomes rise, people can afford the luxury of saving a higher proportion of their income. Therefore, as income rise, spending increases at a lower rate than disposable income. People with high incomes have a lower average propensity to spend.

    Implications of Consumption Function

    If you cut income tax for those on low income, they tend to have a higher marginal propensity to consume this extra income. Therefore, there is a large increase in spending. People with high incomes will tend to have a lower marginal propensity to consume. If they benefit from a tax cut, they will save a greater proportion.

    Shift in the Consumption Function

     

    consumption-function

    In this diagram, the consumption function has shifted to the right. (C1 to C2). This means consumers are spending a smaller % of their income. This could be due to a fall in property prices which decrease consumer confidence and lead to lower consumer spending.

     

    Increased Marginal Propensity to Consume

    consumption-function

    In this diagram, the consumption function has become steeper. This means the value of c (MPC) has increased. Therefore, people are spending a higher % of income. This could be due to rising confidence and easier availability of credit.

    Limitations of Consumption Function

    In the real world people are influenced by other factors

    • Life Cycle factors – e.g. students more likely to borrow and spend during university days.
    • Behavourial factors – e.g. people may be influenced by general optimism

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