Consumption

The Consumption Function

The single most important factor that determines how much households want to spend on consumption is their income. The relationship between consumption expenditure and income is called the consumption function.

The simplest form of the consumption function assumes that as income changes, consumption changes by a constant proportion. Even when income is zero, some consumption still takes place — people must eat, for instance. This level of consumption that does not depend on income is called autonomous consumption.

The consumption function is written as:

Here:

• $C$ is total consumption expenditure by households.
• $\overline{C}$ (read as "C bar") is autonomous consumption — the part of consumption that is independent of income. It is positive even when $Y = 0$.
• $cY$ is induced consumption — the part that depends on income.
• $c$ is the marginal propensity to consume (MPC).

Marginal Propensity to Consume (MPC)

The marginal propensity to consume is the rate at which consumption changes when income changes. Formally:

where $\Delta C$ is the change in consumption and $\Delta Y$ is the change in income.

What values can MPC take?

When income changes, the change in consumption can never exceed the change in income — you cannot spend more than the extra income you receive. So the maximum value of $c$ is 1. At the other extreme, a consumer might choose not to change consumption at all even when income changes; in that case $c = 0$. In practice, MPC usually lies between 0 and 1 (inclusive of both endpoints). This means that when income increases, a household either:

• does not increase consumption at all (MPC = 0),
• uses the entire increase in income for consumption (MPC = 1), or
• uses only part of the increase for consumption (0 < MPC < 1).

A Numerical Example: Imagenia

Consider a country called Imagenia whose consumption function is:

• Autonomous consumption $\overline{C} = 100$. Even if Imagenia has zero income, its citizens still consume Rs 100 worth of goods.
• Marginal propensity to consume $c = 0.8$. If income rises by Rs 100, consumption rises by $0.8 \times 100 = \text{Rs }80$.

Savings and the Marginal Propensity to Save (MPS)

Savings is that part of income which is not consumed:

The marginal propensity to save (MPS) is the rate of change in savings as income increases:

Since $S = Y - C$, we can derive the relationship between MPS and MPC:

Average Propensities …