Unit 2: Consumption Function
Course: Intermediate Macroeconomics (ECODSC 252)
This unit examines the various theories that explain consumer behavior and the relationship between income and consumption, moving from the basic Keynesian model to advanced modern hypotheses.
1. Keynesian Consumption Function
John Maynard Keynes proposed the Psychological Law of Consumption, stating that consumption increases as income increases, but not by as much as the increase in income.
Formula: C = a + bY
- C: Total Consumption.
- a: Autonomous Consumption (consumption even if income is zero).
- b: Marginal Propensity to Consume (MPC), where 0 < b < 1.
- Y: Disposable Income.
Key Characteristics:
- Average Propensity to Consume (APC): The ratio of C to Y (C/Y). As income rises, APC declines.
- Marginal Propensity to Consume (MPC): The change in C divided by the change in Y (ΔC/ΔY). It remains constant in this simple linear model.
2. Absolute Income Hypothesis (AIH)
The Absolute Income Hypothesis, primarily associated with Keynes, suggests that current real consumption is a function of current absolute disposable income.
- It distinguishes between short-run and long-run consumption behavior.
- Short-run data showed that APC declines as income rises, but long-run data (Kuznets) suggested APC is constant.
3. Relative Income Hypothesis (RIH)
Developed by James Duesenberry, RIH argues that consumption depends on relative income rather than absolute income.
Core Concepts:
- Demonstration Effect: Individuals consume more to "keep up with the Joneses" or imitate the consumption patterns of higher-income groups.
- Ratchet Effect: When income falls, consumption does not fall proportionately because people are reluctant to reduce a standard of living they have already achieved. Consumption stays high, "ratcheting" the function upward.
4. Permanent Income Hypothesis (PIH)
Milton Friedman proposed that people base their consumption on permanent income (long-term average income) rather than temporary fluctuations.
Formula: C = k . Yp
- Yp: Permanent Income.
- k: Constant proportion of permanent income consumed.
- Transitory Income (Yt): Temporary windfalls or losses (e.g., lottery win or unexpected bill). PIH suggests Yt is mostly saved and does not significantly affect current consumption.
5. Modigliani’s Life-Cycle Hypothesis (LCH)
Franco Modigliani’s theory suggests that individuals plan their consumption and savings behavior over their entire life cycle to smooth consumption.
Life Stages:
- Early Life: Individuals borrow against future income to fund education and early consumption.
- Middle Life (Working Years): Income exceeds consumption; individuals save for retirement and pay off debt.
- Later Life (Retirement): Individuals "dissave" by spending their accumulated wealth.