Q: Critically examine different Consumption theories?

Ans:

There are different Consumption Theories presented by different economist:

Consumption Theories:

John Maynard Keynes: consumption and current income

Irving Fisher and Intertemporal Choice

Franco Modigliani: the Life-Cycle Hypothesis

Milton Friedman: the Permanent Income Hypothesis

Robert Hall: the Random-Walk Hypothesis

Keynesian Consumption Function

When Keynesian Cross model and the IS-LM model is studied, we did introduce the Keynesian

Consumption Function:

C = C0 + cY

C = consumption expenditure

Y = disposable income

C = autonomous consumption (intercept of the line)

c = marginal propensity to consume (slope of the line)

The main features of that function are:

a) The only determinant of current aggregate consumption is current income;

b) The Marginal Propensity to Consume (MPC) is 0 < c < 1;

c) The Average Propensity to Consume (APC) Ct/Yt = Co/Yt + c is decreasing with income;

The properties a), b) and c) are called the Keynes Conjectures.

Property b) means that only a part of current income is consumed and so a proportion 1-c

becomes saving.

Property c) says that as income increases (meaning consumers become richer) consumers will

save a larger fraction of income.

Graphically the Keynes Consumption function looks like:

The slope of any ray connecting zero with a point on the consumption function is the Average

Propensity to Consume. As income increases a ray connecting zero with a point on the

production function becomes flatter meaning that the slope is decreasing.

Is the Keynesian Consumption function a good representation of consumers’ behavior?

By looking at early empirical evidence (in the 30s and 40s) we had:

1) Cross-sectional evidence:

this was evidence coming from surveys about households at a given point of time. For example

a sample of 1000 consumers in 1934. The results from this evidence were:

a) Richer households consumed more than poorer ones ⇒ MPC > 0

b) Richer households saved more than poorer ones ⇒ MPC < 1.

c) Richer households saved larger fractions of their income ⇒ APC ↓ asY ↑.

d). The correlation between current income and current consumption was found to be very

strong (this was found during the Great Depression).

Therefore according to this evidence it seemed that the Keynesian Consumption Function was a

good representation of consumers’ behaviour.

2) Time series evidence:

in 40s new pieces of evidence about aggregate consumptions were found by Simon Kuznets (a

Nobel prize winner). He created a set of data from the US national accounts from 1869 to the

1940s on aggregate Y and C. According to the Keynes Consumption Function aggregate

consumption should grow more slowly than income. This is because as Y increases, C also

increases but proportionately less than income. Moreover as income increases APC should

decrease. Kuznets found that the ratio C/Y was very stable in long time series data. This implies

that C grew at the same rate as income and as income increased APC did not fall.

Therefore we have two different pieces of evidence giving very different results.

The difference between the two was that the first one was cross-sectional in detail (they looked at

a snapshot of the economy at a point)

whereas Kuznets’s study was of a time series nature (it looked at the economy over many points

in time).

So the evidence seemed to indicate that there were two consumption functions:

a short-run Consumption function which seemed to conform to Keynes’s conjectures and a

longrun consumption function in which the APC was basically constant. This is known as the

Consumption Puzzle.

Psychological Law of Consumption By J.M Keynes:

 

J.M. Keynes, in his book ‘General Theory’ analyzed the consumption behavior of the

community on the basis of human psychology. He propounded a law which is known

as Psychological Law of Consumption.

 

Statement:

 

According to this law:

 

"The household sector spends a major part of its income on the purchase of consumer goods and

services such as food, clothing, medicines, shelter etc., for personal satisfaction. The expenditure

on consumption (C) is the largest component of aggregate expenditure. Whatever is not

consumed out of disposable income is by definition called saving (S)".

Assumptions:

(a)   Habits of people regarding spending do not change or that the propensity to consume

remains the same or stable.

(b)   The economic conditions remain normal.  There is no hyper-inflation or war or other

abnormal conditions.

(c)    The economy is a free-market economy.  There is no government intervention.

(d)   The important characteristic of the slope of consumption function is that the marginal

propensity to consume (mpc) will be less than unity.  This results in low-consumption

and high-saving economy.

Formula:

Disposable Income = Consumption + Saving

 I = C + S

 Explanation:

 

According to Keynes, the level of consumption in a community depends upon the level of

disposable income. As income increases, consumption also increases but it increases not as fast

as income i.e., it increases at a diminishing rate. This relationship between consumption and

disposable income is called consumption function.

 

In the words of Keynes:

 

“Men are disposable as a rule and on the average to increases their consumption as their

income increases, but hot by as much as the increases in their income.”

 

Properties of Consumption Behavior of Community:

 

The psychological law of consumption brings out the following properties of the consumption

behavior of the community:

 

(i) The level of consumption is directly functionally related to the level of disposable income =

C = f(y)

 

(ii) With the rise in the level of income, the consumption level also rises, but at a decreasing rate

= ΔC  <  Δy

 

(iii) As the level  of income increases, the households devote a part of the increase saving.

Symbolically: ΔY = ΔC + ΔS

 

The Keynesian consumption function is now explained with the help of schedule and a curve.

 

Schedule:( in billion)

Disposable

Income (Y)Consumption (C) Saving (S) APC (C/Y) MPC (ΔC/ΔY)

0 50 -50

100 100 0 1.00 0.5

200 150 50 0.75 0.5

300 200 100 0.67 0.5

 

In the schedule, it is shown that as the nation’s disposable income increases, the aggregate

consumption at various levels of income also increases but at a decreasing rate.

 

The same data is now shown in graph 30.1 below:

 

Diagram/Graph:

 

 

Following are the observations about the functional relationship between the national disposable

income and the economy’s aggregate expenditure.

 

(i) At every point on the 450 line OY, a vertical line drawn to the income axis is at the same

distance from the origin as a horizontal line drawn to the consumption axis. The 450 line thus is

the line along which expenditure equals real income.

 

(ii) The consumption function is represented by consumption line (C). The consumption line C is

positively sloped indicating that as the disposable income increases, the expenditure in the

economy also increases.

 

(iii) The consumption line (C) intercepts at Y axis showing negative saving of $50 billion during

a short period.

 

(iv) At point B the consumption line (C) intersects the 450 helping line (OY) saving. At point B,

consumption equals disposable income and there is zero saving. B is called the break even point.

 

(v) Left to the point B, the consumption line C is above the income line Y. It indicates negative

saving.

 

(vi) Right to the point B, the consumption line C is below the income line Y. It denotes positive

savings.

Implications:

According to Keynesian theory, the mpc is less than unity, which brings out the following

implications:

(a)   Since consumption largely depends on income and consumption function is more or less

stable, it is necessary to increase investment fill the gap of declining consumption as income

increases.  If this is not done, the increased output will not be profitable.

(b)   When the income increases, and the consumption are not increased, there is a danger of

over-production.  The government will have to step in to remedy the situation.  Therefore, the

policy of laissez-faire will not work here.

(c)    If the consumption is not increased, the marginal efficiency of capital (MEC) will

diminish.  The demand for capital will also diminish, and all the economic progress will come to

a standstill.

(d)   Keynes’ Law explains the turning points in the business cycle.  When the trade cycle has

reached the highest point of prosperity, income has gone up.  But since consumption does not

correspondingly go up, the downward cycle starts, for demand has lagged behind.  In the same

manner, when the business cycle has touched the lowest point, the cycle starts upwards, because

consumption cannot be diminished beyond a certain point.  This is due to the stability of mpc.

(e)    Since the MPC is less than unity, this law explains the over-saving gap.  As income goes on

increasing, consumption does not increase as much.  Hence saving process proceeds

cumulatively and there arises a danger of over-saving.

(f)     This law also explains the unique nature of income generation.  If money is injected into

the economic system, it will increase consumption but to a smaller extent than increase in

income.  This again is due to the fact that consumption does not increase along with increase in

income.

Summing up, the relationship between consumption and disposable income is referred to as

consumption function. A consumption function tells how much households plan to consume at

various levels of disposable income.

Absolute Income Theory of Consumption

Drift Theory of Consumption

On the first attempts to reconcile the short run and long run consumption functions was by Arhur

Smithies and James Tobin. They tested Keynes absolute income hypothesis in separate studies

and came to the conclusion that the short run relationship between consumption and income is

non-proportional but the time series data show the long run relationship to be proportional.

The latter consumption income behavior results through an upward shift or drift in the short run

non proportional consumption function due to factors other than income.

Smithies and Tobin discuss the following factors:

1. Asset Holdings

Tobin introduced asset holdings in the budget studies of negro and white families to test

this hypothesis. He came to the conclusion that the increase in the asset holdings of

families tends to increase their propensity to consume thereby leading to an upward shift

in their consumption function.

2. New Products

Since the end of the second world war, a variety of new household consumer goods have

come into existence at a rapid rate. The introduction of new products tends to shift the

consumption function upward.

3. Urbanisation

Since the post world war there has been an increased tendency toward urbanisation. This

movement of population from rural to urban areas has tended to shift the consumption

function upward for the reason that the propensity to consume of the urban wage earners

is higher than that of the farm workers.

4. Age Distribution

There has been a continuous increase in the percentage of old people in the total

population over the long run. Though the old people do not earn but they consume

commodities. Consequently, the increase in their numbers has tended to shift the

consumption function upward.

5. Decline in Saving Motive

The growth of social security system makes automatic saving and guarantees income

during illness. Redundancy disability and old age has increased the propensity to

consume.

6. Consumer Credit

The increasing availability and convenience of short term consumer credit shifts the

consumption function upward. The greater case of buying consumer goods with credit

cards, debit cards, use of ATMs and cheques and availability of installment buying

causes an upward shift in the consumption function.

7. Expectation of income increasing

Average real wages of workers have increased and they expect them to rise in the future.

These cause an upward shift in the consumption function. Those who expect higher

future earnings tend to reduce their savings or even borrow to increase their present

consumption.

The consumption drift theory is explained in the diagram 3 where CL is the long run

consumption function which shows the proportional relationship between consumption

and income as we move along it. CS1 and CS2 are the short run consumption functions

which cut the long run consumption function CL at points A and B. but due to the factors

mentioned above, they tend to drift upward from point A to point B along the curve CL

curve.

Each point such as A and B on the CL curve represents an average of all the values of

factors included in the corresponding short run functions, CS1 and CS2 respectively and

long run function, CL connecting all the average values. But the movement along the

dotted portion of the short run consumption functions, CS1 and CS2 would cause

consumption not to increase in proportion to the increase in income.

Its Criticisms

The great merit of this theory is that it lays stress on factors other than in income which affect the

consumer behavior. In this sense, it represents a major advance in the theory of the consumption

function. However it has its short comings.

1. The theory does not tell the rate of upward drift along the CL curve. It appears to be a

matter of chance.

2. It is just a coincidence if the factors explained above cause the consumption function to

increase proportionately with increase in income so that the average of the values in the

short run consumption function equals a fixed proportion of income.

3. According to Duesenberry all the factors mentioned as causes of the upward shift are not

likely to have sufficient force to change the consumption savings relationship to such an

extent as to cause the drift.

4. Duesenberry also points out that many of the factors such as decline in saving motive

would lead to a secular fall in the consumption function. Such saving plans as life

insurance and pension programs tend to increase savings and decrease the consumption

function. Moreover, people want more supplementary savings to meet post retirement

needs which tend to decrease their current consumption.

Relative Income Hypothesis Theory by Dusenberry: 

The Relative Income Hypothesis was first introduced by Dorothy Brady and Ross Friedman.  It

states that the consumption expenditure does not depend on the absolute level of income but

instead the relative level of income.

According to Dusenberry, there is a strong tendency for the people to emulate and imitate the

consumption pattern of their neighbours.  This is the ‘demonstration effect’. 

Duesenberry states that

(1) Every individual’s consumption behaviour is not independent but interdependent of the

behaviour of every other individual and

(2) That consumption relations are irreversible and not reversible in time.

Statement of the Theory:

In formulating theory of the consumption function, Duesenberry writes

“A real understanding of the problem of consumer behavior must begin with a full recognition

of the social character of consumption patterns.” By the “Social character of consumption

patterns” he means the tendency in human beings not only “to keep up with the Joneses” but

also to surpass the Joneses. Joneses refers to rich neighbors.

The relative income hypothesis also tells us that the level of consumption spending is

determined by the households’ level of current income relative to the highest level of income

earned previously.  People are then reluctant to revert to the previous low level of

consumption.  This is ‘ratchet effect’.

The relative income theory states that if current and peak incomes grow together changes in

consumption are always proportional to change in income.  That is, when the current income

rises proportionally with peak income, the APC remains constant.

Permanent Income Hypothesis by Miltom Friedman

Due to Milton Friedman (1957), The basic idea is that people’s income has a random element

to it and also a known element to it and that people try to smooth the random part.

Friedman draws a distinction between permanent consumption and transitory

consumption. Permanent consumption stands for that part of consumer expenditure which the

consumer regards as permanent and the rest is transitory.  

Distinction can also be made between durable and non-durable consumer goods.  Durable

consumption is concerned with purchasing capital assets and in the case of non-durable goods

the act of consumption destroys the good.  

Ordinary consumer expenditure relates to non-durable consumption, i.e., consumption of goods

which are quickly used in consumption.  These are the‘flow’ items since a flow of them is being

continuously consumed.  On the other hand, durable consumption, which relates to the purchase

of capital assets, is an act of investment.  These are ‘stock’ items.

According to Friedman, permanent consumption (Cp) is a function of:

(i)        Rate of interest,

(ii)       Rates of consumer’s income from property and his personal effort, i.e., human

and non-human wealth, and

(iii)     Consumer’s preference for immediate consumption multiplied by permanent

income (Yp).

The permanent income theory really emphasises the important role of capital assets or wealth in

determining the size of consumption. It shows how both income and consumption are closely

linked with the consumer’s wealth.  It is capital and wealth, which affects the level of

consumption rather than consumer’s income.

Define Current Income Y as:

Y = Y P + Y T

YP = Permanent Income: this represents the long run (average) income which people expect to

persist into the future.

Y T = Transitory Income: this represents temporary deviations from average income.

This is the random part of income that is unexpected. It can be positive or negative;

Example:

suppose that you are working and receive an annual salary of £30000. Suppose that you expect to

get that salary every year in the future. Then £30000 represents the permanent part of your

income and you expect to get £30000 every year also in the future. However assume that this

year, since you have been very productive, you receive a bonus of £5000. This bonus represents

a transitory income since you do not expect to get it every year from now on.

Fisher’s Two Period Model of Consumption

The Keynesian Consumption Function is not microfounded. It is not derived from a model of

optimal behaviour of consumers. Here we look at microfoundations of aggregate consumption

and see if the Keynesian Consumption Function is consistent with a microfounded analysis. The

following analysis is due to Irving Fisher (the one of the Fisher Effect). The model is in practice

very similar to the one we did for Ricardian Equivalence.

Consider a representative consumer (there are many consumers but they are all equal) that lives

for only two periods. There is no government. The consumer is rational and forward looking.

Meaning: he maximises his own utility over his lifetime subject to his lifetime budget constraint

and in deciding what to do today he takes into account what it will happen in the future. The

consumer can lend and borrow at the real interest rate r.

The budget constraint in period 1 is:

C1 + S1 = Y1

Where C is consumption, S denotes saving and Y is income. In period 2 the budget

Constraint is:

C2 = Y 2+ (1+ r) S1

Obviously in period 2 there is no saving since the consumer dies and so it will consume all his

income in period 2.

Intertemporal budget constraint of our consumer is:

Graphically the intertemporal budget constraint looks like:

On the vertical axis we put consumption in period 2 and on the horizontal axis the consumption

in period 1. The intertemporal budget line in the graph shows all combinations of C1 and C2 that

just exhaust the consumer’s resources. The point C1 = Y1 and C2 = Y2 showed in the graph is

always feasible and is on the budget line. Our consumer can move along the budget line by

saving and borrowing. The intertemporal budget constraint implies a trade-off between

consumption in period 1 and in period 2. If our consumer wants to consume more in period 2

compared to C2 = Y2, he must consume less in period 1 in order to save.

The Life Cycle Hypothesis (LCH) of Consumption

The Keynesian Consumption Function while able to explain aggregate consumption of an

economy at a point in time was not able to explain it over time. This is what we called

“consumption puzzle”.

Background:

In the early 1950s, Franco Modigliani and his student, Richard Brumberg, developed a theory

based on the observation that people make consumption decisions based both on the resources

available to them over their lifetime and on which is their current stage of life.

Therefore there was the need to have a theory to explain the behavior over time of the aggregate

consumption. Two theories were developed at about the same time, one theory was proposed by

Franco Modigliani (Nobel Prize in economics) called the Life Cycle Hypothesis.

Modigliani and Brumberg observed that individuals build up assets at the initial stages of their

working lives. Later on during retirement, they make use of their stock of assets. The working

people save up for their post-retirement lives and alter their consumption patterns according to

their needs at different stages of their lives.

Extending the idea of the Fisher’s model the Life Cycle model says that it is not only income in

the current period that affected people’s observed consumption choices, but also income they

expected in the future. The Life Cycle Hypothesis is that the income of people varies in a known

way (systematic way) over people’s lives and that people use savings to move income from high-

income periods to low-income periods in order to smooth consumption over their lifetime.

Basic Assumptions of the Life Cycle Hypothesis

a) Perfect Knowledge of Lifetime: individuals know with certainty how much they are going to

live and when they are going to die;

b) Uniform Consumption: individuals prefer to have a constant stream of consumption over

their lifetime;

c) Zero Bequests: individuals do not die with positive income. They consume all their

accumulated saving;

d) Zero Real Interest Rate: this is a simplifying assumption;

e) Ability to Calculate Future Income: individuals are able to guess correctly what their future

income is going to be;

A Basic Life Cycle Model

Consider a representative consumer (many consumers all equal) that is going to live

until time T. Denote with:

- W the initial wealth of the consumer (this includes financial and real assets).

- Y the constant annual income that the consumer is going to earn until retirement.

- R is the number years until retirement.

The Lifetime Resources of the consumer is:

W + RY ---------------------- Equation (1)

Equation (1) is the discounted lifetime resources (remember that r = 0 by assumption). To

achieve constant consumption over time our consumer divides lifetime resources equally over

time

Since over time aggregate wealth and aggregate income tend to grow together (given 12 the

assumption of consumption smoothing if income increases, consumption remains constant and

so saving (and wealth) will grow proportionally to income) then APC should remain stable over

time.

Graphically, an example of a consumption profile of an individual under the Life Cycle

hypothesis looks like:

ROBERT HALL AND THE RANDOM-WALK HYPOTHESIS

Robert Hall was first to derive the implications of rational expectations for consumption. He

showed that if the permanent-income hypothesis is correct and if consumers have rational

expectations, then changes in consumption over time should be unpredictable. When changes

in a variable are unpredictable, the variable is said to follow a random walk.

According to Hall, the combination of the permanent-income hypothesis and rational

expectations implies that consumption follows a random walk.