consumption function and investment function chapter 2
TRANSCRIPT
Consumption Function &
Investment FunctionVaghela Nayan K.
SDJ International collegeS.Y.Bcom
The Concept of Consumption Function As the demand for a good depends upon its price,
similarly consumption of a community depends upon the level of income. In other words, consumption is a function of income. The con sumption function relates the amount of consumption to the level of income. When the income of a community rises, consumption also rises.
How much consumption rises in response to a given increase in income depends upon the marginal propensity to consume. It should be borne in mind that the consumption function is the whole schedule which describes the amounts of consumption at various levels of income.
Linear Consumption Function
Consumption function should be carefully distinguished from the amount of consumption. By consumption function is meant the whole schedule which shows consumption at various levels of income, whereas amount of consumption means the amount consumed at a specific level of income. The schedule described above reflects the consumption function of a com munity i.e., it indicates how the consumption changes in response to the change in income.
In the above schedule it will be seen that at the level of income equal to Rs. 1200 crores, the amount of consumption is Rs. 900 crores. As the national income increases to Rs. 1500 crores, the consumption rises to Rs. 1125 crores. Thus, with a given consumption function, amount of consumption is different at different levels of income.
The above schedule of consumption function reveals an important fact that when income rises, consumption also rises but not as much as the income. This fact about consumption function was emphasized by Keynes, who first of all evolved the concept of consumption function. The reason why consumption rises less than income is that a part of the increment in income is saved.
Consumption demand depends on income and propensity to consume. Propensity to con sume depends on various factors such as price level, interest rate, stock of wealth and several subjective factors. Since Keynes was concerned with short run consumption function he assumed price level, interest rate, stock of wealth etc. constant in his theory of consumption. Thus with these factors being assumed constant in the short run, Keynesian consumption function considers consumption as a function of income. Thus
C= f(Y)
Keynesian consumption function has been depicted by CC’ curve in Fig. 6.1 in which along the X-axis national income is measured and along the Y-axis the amount of consumption is measured. In this figure, a line OZ making 45° angle with the X-axis, has been drawn. Because line OZ makes 45° angle with the X-axis every point on it is equidistant from both the X-axis and Y-axis.
Therefore, if consumption function curve coincides with 45° line OZ it would imply that the amount of consumption is equal to the income at every level of income. In this case, with the increase in income, consumption would also increase by the same amount.
As has been said above, in actual practice consumption increases less than the increase in income. Therefore, in actual practice the curve depicting the consumption function will deviate from the 45° line. If we represent the above consumption schedule by a curve, we would get the propensity to consume curve such as CC in Fig. 6.1.
It is evident from this figure that the consumption function curve CC’ deviates from the 45° line OZ. At lower levels of income, the consumption function curve CC lies above the OZ line, signifying that at these lower levels of income consumption is greater than the income.
It is so because at lower levels of income, a nation may draw upon its accumulated savings to maintain its consumption standard or it may borrow from others. As income increases, consumption also increases and at the income level OY0, consumption is equal to income.
Beyond this, with the increase in income, consumption increases but less than the increase in income and therefore, consumption function curve CC lies below the 45° line OZ beyond Y0. An im portant point to be noted here is that beyond the level of income OY0, the gap between con sumption and income is widening. The difference between consumption and income represents savings. Therefore, with the increase in income, saving gap also widens and as we shall see later, this has a significant implication in macroeconomics.
It is useful to point out here that when the consumption function of a community changes, the whole consumption function curve changes or shifts. When propensity to con sume increases, it means that at various levels of income more is consumed than before.
Therefore, as a result of increase in propensity to consume of the community, the whole consumption function curve shifts upward as has been shown by the upper curve C’C’ in Fig. 6.2. On the contrary, when the propensity to consume of the community decreases, the whole consumption function curve shifts downward signifying that at various levels of in come, less is consumed than before.
Keynes's Psychological Law of Consumption
The normal Physiological Law holds that when the real income of the community increases or decreases , its consumption will increase or decrease, but no so fast.
In other words, as income increases, consumption also increases but not in the same proportion as increase in income, and vice versa.
This is because, as one adds to one’s consumption with expansion of one’s income, he comes closer to the point of saturation beyond which consumption is less likely to be stretched.
It means, the proportion of income saved increases as income increases.
Keynes’ Law of consumption is related to three different propositions:
1. When the income of the community increases, its consumption expenditure also increases but by somewhat smaller amount. While proportion of income saved increases with the increase in the level of income.
2. It means the increased income will be divided into to proportion as saving and spending.
3. It is unlikely that an increase in income will lead to either less spending or less saving than before, rising income is often accompanied by increased saving and falling income by decreased saving.
Assumption of the Keynes’ Psychological Law of Consumption:
1. It is assumed that in short run, habits, tastes, customs, price level, size of population, pattern of Income distribution, etc. do not change and that consumption expenditure depends on income only.
2. The conditions are normal and the economy is not facing any abnormal or extraordinary circumstances such as war, floods or famines, inflation, etc.
3. The existence of a wealthy capitalist economy based on laissez faire policy, that is, it is a free economy in which there are no government restrictions on consumption and saving.
Implication of the Law:1. This law invalidates the Say’s Law of Market as Income
increases, expenditure also increases but not in the same proportion, but it increases in less proportion as compared to income. Therefore, it is not correct to say that supply creates its own demand.
2. The law underlines the importance of investment in any programme of full employment. As the gap between income and expenditure arises there, which is being bridged by increase in investment or else it will lead to depression and unemployment.
3. It also gives importance to state intervention. As consumption increases in less proportion to income, there arises a situation of over- production and general unemployment. Here, the need for appropriate monetary and fiscal policy arises.
4. The law also explains the turning point of business cycle. The downward turning point from the boom is explained by the fact that although people’s income increases, the consumption expenditure does not increases in the same proportion, likewise the upper turning point from a depression is explained by the fact that although people’s income decreases the consumption expenditure cannot be reduced in same proportion: a minimum level of consumption has to be incurred.
Propensity to consume In dealing with the consumption function or the
propensity to consume, Keynes considered its two technical attributes: (1) Average propensity to consume and (2) marginal propensity to consume.
1. Average propensity to consume: The average propensity to consume is defined as the ratio of aggregate or total consumption to aggregate income in a given period of time.
APC=C/YIt follows that the average propensity to save will be the ratio of aggregate or total savings to aggregate income in a given period of time.
APC=S/Y
The economic significance of the APC is that it tells us what proportion of total cost of a given output from planned employment can be expected to be recovered by selling consumer goods alone.
It tells us what proportion of total amount of goods and services demanded by the community originates in the demand for consumer goods.
The average propensity to save tells what proportion of total cost of a given output will have to be recovered by the sale of capital goods.
Other things remain equal, the relative development of consumer goods and capital goods industries in an economy depends on APC and APS.
2. Marginal Propensity to Consume:
The Marginal propensity to consume is the ratio of the change in the level of aggregate consumption to a change in level of aggregate income. It refers to the effect of additional income on consumption.
MPC can be found by dividing a change in consumption by a change in income;
MPC= ΔC/ΔY.Where Δ (delta) indicates the change
C denotes consumptionY denotes income.
Here we have taken linear consumption function and that is the reason why the above schedule shows 0.8 or 80% MPC for each level of income.
The MPC is always positive but less than one. This is because of the psychological law of consumption as it purports that the increase in consumption will be less as compared to increase in income.
Here, as people are also keen to save their part of income and therefore we can say that,
MPC= ΔC/ΔY < 1 Another significance about the concept is marginal
propensity to save, which can be found by using following equation:
MPC= 1- MPC
Factors affecting the Consumption function:A. Subjective Factors: The factors which may change the
slope and position of the consumption function.1. The motive of precaution.2. The motive of foresight; anticipated future needs.3. The motive of calculation; large real consumption is preferred at
later date than to a smaller immediate consumption. (desire to earn interest.)
4. The motive of Improvement; Gradual increase in standard of living is desired.
5. The Motive of independence; desire to enjoy the power to do things independently.
6. The motive of Enterprise; desire to secure and establish business projects.
7. The motive of Pride; desire to possess a fortune.8. The motive of liquidity; desire to face emergencies and
difficulties successfully.
B.Objective Factors: factors that are capable of rapidly changing the shape and amount of consumption function.1. Windfall gains or losses: Due to windfall gains to
people, the consumption can change suddenly. Sudden loss can reduce the level of consumption unexpectedly.
2. Fiscal policy: the changes made by the government in fiscal policy can change the pattern of consumption. Imposition of heavy taxes reduces the disposable income of the people and leads to reduction in the level of consumption and vice-versa.
3. Change in Expectation: The expectations regarding future changes also affects the consumption of the community. Expected war may increase the consumption because of the probable future scarcity.
4. The rate of interest: Significant rise in rate of interest may induce people to reduce their consumption at each income level, because people will save more in order to make advantage of the high interest rates.
5. Changes in wage rate: As the workers are having higher propensity to consume, increased wage rate will also increase the level of consumption. The consumption curve shift up with the increase in wage rate.
6. Financial policies of the corporation: If the joint stock companies are retaining higher amount profit for expansion purpose and giving very less amount of dividend to the shareholders, the consumption curve shifts downward.
7. Pattern of income distribution: MPC is different for the each section of the society. Generally the poor has higher propensity to consume than the rich. Hence if the income is transferred from the rich to poor, total consumption in the economy will increase and consumption curve will shift up.
8. Amount of wealth: People who possess higher amount of wealth are less worried about the future uncertainties of life. They save less and consume more out of their current income. Conversely people who possess no wealth will save more and consume less out of the current income.
Significance of the concept of Consumption function:
1. The concept of consumption function disproves Say’s law of market that supply creates its own demand.
2. Due to stability of the concept in the short run, it underlines the importance of investment in the theory of income and employment.
3. The concept provides satisfactory explanation to the up-turns and down-turns in business cycle.
4. It also helps in explaining the over saving phenomenon and declining trend of marginal efficiency of capital in rich countries.
5. It is also helpful in understanding the concept of multiplier.
Investment Function In ordinary parlance, investment means to buy shares, stocks,
bonds and securities which already exist in stock market. But this is not real investment because it is simply a transfer of existing assets. Hence this is called financial investment which does not affect aggregate spending. In Keynesian terminology, investment refers to real investment which adds to capital equipment.
It leads to increase in the levels of income and production by increasing the production and purchase of capital goods. Investment thus includes new plant and equipment, construction of public works like dams, roads, buildings, etc., net foreign investment, inventories and stocks and shares of new companies. In the words of Joan Robinson, “By investment is meant an addition to capital, such as occurs when a new house is built or a new factory is built. Investment means making an addition to the stock of goods in existence.”
Capital, on the other hand, refers to real assets like factories, plants, equipment, and inventories of finished and semi-finished goods. It is any previously produced input that can be used in the production process to produce other goods. The amount of capital available in an economy is the stock of capital. Thus capital is a stock concept.
To be more precise, investment is the production or acquisition of real capital assets during any period of time. To illustrate, suppose the capital assets of a firm on 31 March 2004 are Rs 100 crores and it invests at the rate of Rs 10 crores during the year 2004-05. At the end of the next year (31 March 2005), its total capital will be Rs 110 crores. Symbolically, let I be investment and К be capital in year t, then It = Kt– Kt- 1.
Capital and investment are related to each other through net investment. Gross investment is the total amount spent on new capital assets in a year. But some capital stock wears out every year and is used up for depreciation and obsolescence. Net investment is gross investment minus depreciation and obsolescence charges for replacement investment. This is the net addition to the existing capital stock of the economy.
If gross investment equals depreciation, net investment is zero and there is no addition to the economy’s capital stock. If gross investment is less than depreciation, there is disinvestment in the economy and the capital stock decreases. Thus for an increase in the real capital stock of the economy, gross investment must exceed depreciation, i.e., there should be net investment.
As Keynes has pointed out here the importance of investment function as the gap between the income and consumption must be bridged by investment.
Investment function is viewed in the context of marginal efficiency of capital and the rate of interest. Changes in any of these variable brings about changes in the volume of investment. Thus during a given period, investment is a function of marginal efficiency of capital and tare of interest .
I = F (e, r)I= Investment, F= functione= Marginal efficiency of capital and r= Rate of interest
Determinants of Investment:1. Marginal Efficiency of Capital:
Keynes first introduced the concept of marginal efficiency of capital in the year 1936 and according to him it is a key determinant of investment.
In general marginal efficiency of capital means expected rate of profit, or the expected rate of return over cost or the expected profitability of the capital asset.
MEC means “the rate of discount which would make the present value of the annual returns expected from the capital asset during its life just equal to its supply price.”
According to Kurihara, “MEC is the ratio between the prospective yield of additional capital assets and their supply price. Symbolically:
e = OPWhere, e = MEC
O = expected yield of a capital asset per unit of timeP = Supply price of the asset.
i. Prospective yield from capital asset: It refers to the amount of annual income which an investor expects to get by selling the output of his investment or capital asset, after deducting the running expenses of obtaining that output during its life time. It is the aggregate return from an asset during its life time.
ii. Supply price of the asset: It is a price which an investor has to pay to acquire the capital asset. It is a cost of producing it.
The marginal efficiency of capital can be calculated as follows: SP =R1/ (1+i) + R2 (1+i)2 + Rn/(1+i)n
Where Sp is the supply price or the cost of the capital asset, R1 R2… and Rn are the prospective yields or the series of expected annual returns from the capital asset in the years, 1, 2… and n, i is the rate of discount which makes the capital asset exactly equal to the present value of the expected yield from it.
This i is the MEC or the rate of discount which equates the two sides of the equation. If the supply price of a new capital asset is Rs 1,000 and its life is two years, it is expected to yield Rs 550 in the first year and Rs 605 in the second year. Its MEC is 10 per cent which equates the supply price to the expected yields of this capital asset.
Thus (Sp) Rs 1000 = 550/(1.10) + (605)/(1.10)2 = Rs. 500 + 500 In equation (1), the term R1/(1+i) is the present value (PV) of
the capital asset. The present value is “the value of payments to be received in the future.” It depends on the rate of interest at which it is discounted.
Marginal Efficiency of Capital and Volume of Investment: Along with the supply price and expected yield of the asset,
MEC also depend upon Volume of Investment. Normally the MEC of an asset tends to progressively diminish as investment in that asset increases.
This is because of the following reasons:1. Due to more amount of investment, the asset will be
produced more and due to which the expected yield will tend to decline as they will compete against each other to meet consumers demand and in this process , their general earnings will decline.
2. The supply price of the asset will also increase as more production of the asset will lead to decline in the available resources for the production of asset.
This can be illustrated with the help of schedule and a curve.
Diminishing marginal efficiency of Capital
Investment (Rs. in crores)
MEC (in %)
1000 122000 104000 86000 68000 410000 2
0 2000 4000 6000 8000 10000 120000
2
4
6
8
10
12
14
12
10
8
6
4
2
Diminishing marginal efficiency of Capital
Investment (Rs. in crores)
MEC
(in
%)/
Rat
e of
inte
rest
Marginal efficiency of Capital and Rate of Interest Investment depend on the MEC and the rate of interest. MEC is
again result of the supply price and the prospective yield of capital asset.
The rate of interest on the other hand, is determined by the demand for and supply of money. On demand side, the rate of interest is determined by the liquidity preference of the people and on supply side by supply of money available in the economy.
We can directly compare the MEC and rate of interest as both are ratios.
Such comparison is essential because investment in a capital asset depend on a rational comparison between the supply price of an asset and its demand price.
The supply price of an asset is the sum of prospective yields discounted by MEC, while its demand price is the sum of expected future yields discounted at the current rate of interest.
By comparing the supply price and demand price, the following observations may be made as regards investment decisions:
1. When the marginal efficiency of capital is greater than the rate of interest, that is to say demand price is higher than the supply price , the investor will continue to make fresh investments.
2. When the MEC is equal to the rate of interest, i.e. supply price is equal to demand price, the effect on investment will be neutral.
3. When the MEC is less than the rate of interest, i.e. when the demand price is less than the supply price, the investors will stop making new investments.
This can be explained with the help of schedule and a curve.
Supply price (`)
Annual return (`)
MEC Rate of interest
Effect on investment
25000 1000 4% 4% Neutral20000 1000 5% 4% Favourable25000 1000 4% 5% Unfavourabl
e
Factors affecting Marginal Efficiency of Capital:1. Business expectations and Business Confidence: Optimistic
business expectations leads to higher marginal efficiency of capital and pessimistic business environment leads to lower MEC.
2. Stock of Capital goods: Existence of large stock of capital goods will lead to lower MEC because due to large capital stock Marginal productivity of capital will be low and along with that, due to large capital stock, production of finished goods will be large. The market price of the finished goods will tend to decline, so the prospective yield of the capital asset will be low.
3. Technological Progress: inventions and innovations tend to increase the MEC.
4. Development of New Areas: the opening up of New Markets increases the MEC.
5. New Product: As the sale of new product are high and expected revenues are more than the cost, the MEC will be high.
7. Population Growth: Increase in population leads to increase in demand of all kinds of consumer goods and investment goods. MEC will also increase along with the increase in demand and vice-versa.
8. Government policy: in case of imposition of heavy taxes on companies and corporations, MEC will tend to decline. Even indirect taxes will increase the prices of the finished goods and demand will come down. This will reduce the MEC. If state provides infrastructural facilities like transport, communication, power, etc. credit facilities and other subsidies will increase MEC.
9. Political Climate: Political instability, adversely affects the MEC. Stable government and peaceful political relations leads to higher MEC.
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