The Keynesian Consumption function expresses the level of consumer spending depending on three factors.
- Yd = disposable income (income after government intervention – e.g. benefits, and taxes)
- a = autonomous consumption (consumption when income is zero. (e.g. even with no income, you may borrow to be able to buy food))
- b = marginal propensity to consume (the % of extra income that is spent). Also known as induced consumption.
Consumption function formula
- C = a + b 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
In this diagram, the consumption function has shifted to the upwards (to the left. (C1 to C2). This means consumers are spending a higher % of their income. This could be due to a rise in property prices which increases consumer confidence and lead to higher consumer spending.
Increased marginal propensity to consume
In this diagram, the consumption function has become steeper. This means the value of b (MPC) has increased. Therefore, people are spending a higher % of their additional income. This could be due to rising confidence, lower saving 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.
- Behavioural factors – e.g. people may be influenced by general optimism.
Other theories of consumption
Permanent income hypothesis (Milton Friedman) a theory that a person’s consumption is determined, not just by current income, but also future expected income. It suggests that consumers will attempt to ‘smooth consumption’ over their lifetime, e.g. borrowing as a student, running down savings in retirement.
Life-cycle hypothesis (Richard Brumberg & Franco Modigliani). Another theory that people attempt to smooth consumption over their lifecycle. This suggests that spending will be dependent on current income, future expected income and also a function of wealth. See: Life-cycle hypothesis