Consumption function

In economics, the consumption function describes a relationship between consumption and disposable income.^[1]^[2] The concept is believed to have been introduced into macroeconomics by John Maynard Keynes in 1936, who used it to develop the notion of a government spending multiplier.^[3]

YouTube Encyclopedic

1/3
Views:
183 264
46 405
267 325

Transcription

Male: What I want to do in this video is introduce you to the idea of a consumption function. It's a very simple idea. It's really just the notion that income, income in aggregate in an economy can drive consumption in aggregate in an economy. Just to make things tangible, I will construct a consumption function for a hypothetical economy, and we can debate whether we can construct a better one. All the numbers don't have to be exactly what I'm about to do, but this is just to make things concrete in your mind. Maybe we have a hypothetical economy where consumption is going to be equal to ... well, maybe there's some base level of consumption even if there's no aggregate income in our economy. It's hard to image, but let's say there isn't. There will still be consumption. Maybe people can do it by digging into their savings. They're essentially using resources that they've already accumulated in some way. Let's say that base level of consumption, let's call that 500. It could be billions of dollars or gold coins or clamshells or whatever the unit of measuring economic activity is in our economy. That's our base level of consumption. Then let's say if there is some aggregate income, people will spend 60% of it. I'm just picking these numbers somewhat arbitrarily. Let's say if there's some above and beyond the base level, they're going to spend 0.6 of any aggregate income they have. Actually, to be a little bit more particular, I'll write not just income, I'll write disposable income. I'll want to do that in a different color. They will ... that's not a different color. Above and beyond the base level, they'll spend 60% of their disposable income. I make the distinction, just to clarify our model, between income and disposable income because all of the aggregate income in an economy does not end up in consumers' pockets. Just for a simplification, you might say, "Yeah, some of it ends up in firms' pockets," but the firms, at the end of the day, are owned by individuals, so it can end up in individuals' or consumers' pockets. But some of it goes off to the government. When you think about income, and if you spend any time looking at your pay stub this will become familiar to you, you have your income but you don't end up with all of that in your checking account or your pocket or your savings account. A good fraction of that is taken out for taxes. What you have left over when you subtract taxes out of income, that is your disposable income. That's why I write this here because that's actually a more reasonable thing to say. People will spend 60% of their disposable income. They obviously can't spend a fraction of stuff that they don't have, the stuff that's taken out for taxes. Just to visualize this, we can draw it. This will be a line. This might ring a bell from your early algebra days. Just the variables are different. Instead of a y, we have a c, but that's still the dependent variable. It's a function of disposable income. In algebra you'll often call this the independent variable. The most typical variable is x. It's really the same idea over here. Let me draw this a little bit neater. We can graph this, what's essentially going to be a line. It doesn't have to be a line. We just constructed a consumption function that happens to be a line. This is consumption right over here in the vertical axis. That could be in billions of dollars or clamshells or whatever else. Then right over here we have disposable income. If there is zero disposable income, maybe I'll draw a little table over here. This is I'll call it disposable income and this is consumption. If there's zero disposable income, then this whole term right over here is 0. Then you have 500 billion dollars, or whatever our units are, of base consumption. This would correspond to this point right over here. In the horizontal axis you don't move at all because this is 0. Vertical axis is 500. So you have 500. Let's say disposable income is 1,000 whatever our units are. So this is 500. Let's say this is 1,000 billion clamshells. This could be in billions of clamshells. I don't want to keep having to say that over and over again. What is our consumption going to be in our units? Our consumption is going to be equal to 500 + 0.6 x 1,000 which is equal to 500 + 600 which is equal to 1,100. That would correspond, this right over here, would correspond to; so 1,000, so this might be 1,000 on this axis so this would be 1,100 to this point right over here. That would be the coordinate: 1,000; 1,100. This is a line. Two points make a line. In this particular case we have a consumption function that looks something like this. We picked two points to draw it. If you remember a little bit of your slope, you could view this as your y intercept, or in this case your c intercept, and that your slope would be the .6, and we'll talk more about that in future videos when we dig into the marginal propensity to consume a little bit more. But the one thing I just want to highlight is it's a very simple idea. This does not have to be the consumption function. The consumption functions that we tend to study in introductory economics classes will look like this. It will be a line that has some intersection, some base level of consumption. But one could argue it might be very different. Maybe the consumption function looks like this. Maybe when income is low, for every incremental dollar of income, people are probably going to spend a lot. As they become richer and richer and richer, as their income goes higher and higher, they're going to spend less and less a fraction of their disposable income. Essentially what I'm describing here is a marginal propensity to consume changes. In our first model, we had a very basic marginal propensity to consume. It was constant. For every incremental dollar, .6 of that got spent. So we had a marginal propensity to consume that was constant of 0.6. Marginal propensity to consume. But, you could argue, that maybe a more complex model is justified. That when you have a very high marginal propensity to consume, when people have very little because they have a very low standard of living, they really want to just get a little bit more just so they can live a decent life, but as they get more and more income they say, "Hey, I'm starting to max out my standard of living, "I'll save more and more of it for a rainy day."

Details

Its simplest form is the linear consumption function used frequently in simple Keynesian models:^[4]

C=a+b\cdot Y_{d}

where $a$ is the autonomous consumption that is independent of disposable income; in other words, consumption when disposable income is zero. The term $b\cdot Y_{d}$ is the induced consumption that is influenced by the economy's income level $Y_{d}$ . The parameter $b$ is known as the marginal propensity to consume, i.e. the increase in consumption due to an incremental increase in disposable income, since $\partial C/\partial Y_{d}=b$ . Geometrically, $b$ is the slope of the consumption function.

Keynes proposed this model to fit three stylized facts:^[5]

People typically spend a part, but not all of their income on consumption, and they save the rest. They typically do not borrow money to spend, or borrow money to save.^[6] This fact is modelled by requiring $b\in (0,1)$ .
People with higher income save a higher proportion of the income. This is modelled by ${\frac {C}{Y_{d}}}$ decreasing with $Y_{d}$ .
People, when deciding how much to save, are insensitive to the interest rate.^[6]

By basing his model in how typical households decide how much to save and spend, Keynes was informally using a microfoundation approach to the macroeconomics of saving.^[7]

Keynes also took note of the tendency for the marginal propensity to consume to decrease as income increases, i.e. $\partial ^{2}C/\partial Y_{d}^{2}<0$ .^[8] If this assumption is to be used, it would result in a nonlinear consumption function with a diminishing slope. Further theories on the shape of the consumption function include James Duesenberry's (1949) relative consumption expenditure,^[9] Franco Modigliani and Richard Brumberg's (1954) life-cycle hypothesis, and Milton Friedman's (1957) permanent income hypothesis.^[10]

Some new theoretical works following Duesenberry's and based in behavioral economics suggest that a number of behavioural principles can be taken as microeconomic foundations for a behaviorally-based aggregate consumption function.^[11]

Notes

^ Algebraically, this means $C=f(Y_{d})$ where $f\colon \mathbb {R} ^{+}\to \mathbb {R} ^{+}$ is a function that maps levels of disposable income $Y_{d}$ —income after government intervention, such as taxes or transfer payments—into levels of consumption $C$ .
^ Lindauer, John (1976). Macroeconomics (Third ed.). New York: John Wiley & Sons. pp. 40–43. ISBN 0-471-53572-9.
^ Hall, Robert E.; Taylor, John B. (1986). "Consumption and Income". Macroeconomics: Theory, Performance, and Policy. New York: W. W. Norton. pp. 63–67. ISBN 0-393-95398-X.
^ Colander, David (1986). Macroeconomics: Theory and Policy. Glenview: Scott, Foresman and Co. pp. 94–97. ISBN 0-673-16648-1.
^ Mankiw, N. Gregory (2022). Macroeconomics (11 ed.). New York. 20-1 What Determines Consumer Spending?. ISBN 978-1-319-26390-4. OCLC 1289514240.{{cite book}}: CS1 maint: location missing publisher (link)
^ ^a ^b Keynes, John M. (1936). The General Theory of Employment, Interest and Money. New York: Harcourt Brace Jovanovich. Section 3.8.2. There are not many people who will alter their way of living because the rate of interest has fallen from 5 to 4 per cent, if their aggregate income is the same as before... the short-period influence of the rate of interest on individual spending out of a given income is secondary and relatively unimportant, except, perhaps, where unusually large changes are in question.
^ Solow, Robert M. (2004). "Introduction: The Tobin Approach to Monetary Economics". Journal of Money, Credit, and Banking. 36 (4): 657–663. doi:10.1353/mcb.2004.0067. ISSN 1538-4616. S2CID 154008365. ... recall Keynes's argument that the marginal propensity to consume should be between zero and one, or his discussion about whether the marginal efficiency of investment should be sensitive to current output or should depend primarily on "the state of long-term expectations." Those are microfoundations.
^ Keynes, John M. (1936). The General Theory of Employment, Interest and Money. New York: Harcourt Brace Jovanovich. The marginal propensity to consume is not constant for all levels of employment, and it is probable that there will be, as a rule, a tendency for it to diminish as employment increases; when real income increases, that is to say, the community will wish to consume a gradually diminishing proportion of it.
^ Duesenberry, J. S. (1949). Income, Saving and the Theory of Consumer Behavior.
^ Friedman, M. (1957). A Theory of the Consumption Function.
^ d’Orlando, F.; Sanfilippo, E. (2010). "Behavioral foundations for the Keynesian consumption function" (PDF). Journal of Economic Psychology. 31 (6): 1035. doi:10.1016/j.joep.2010.09.004.

External links

An essay examining the strengths and weaknesses of Keynes's theory of consumption

v t e Consumption
Topics	Consumption function Final consumption expenditure Instant gratification Intertemporal consumption Random walk hypothesis Autonomous consumption Induced consumption Conspicuous consumption
Theories	Absolute income hypothesis Life-cycle hypothesis Permanent income hypothesis Random walk model of consumption Relative income hypothesis
Lists	List of largest consumer markets

v t e Consumer behaviour
Concepts	Consumption Autonomous consumption Induced consumption Consumer culture theory Consumer debt Consumer economy Consumer spending
Research types	Consumer choice Consumer economics Consumer neuroscience Consumer product Marketing research
Consumer attributes	Consumer confidence Consumer confusion Consumer ethnocentrism Consumer socialization Consumer's risk Consumption function Cultural consumer Homo economicus
Processes	Consumers' co-operative Consumer-to-business Factory-to-consumer Consumer service Consumerization

This page was last edited on 7 December 2023, at 20:18

From Wikipedia, the free encyclopedia

YouTube Encyclopedic

Transcription

Details

See also

Notes

Further reading

External links