Meaning of consumption Function And Keynes's psychological law of consumption | Mero solution

Meaning of Consumption Function:
Consumption is defined as an act of spending income for buying goods and services to satisfy current wants. In other words, it refers to the expenditure on consumption of final goods made by household at a given level of income.

Consumption function or propensity to consume refers to the general relationship between two aggregates, i.e. income and consumption.
consumption function establishes functional relationship between income (as an independent variable) and consumption (as a dependent variable). It also shows how consumption varies with given changes in income. But, propensity to consume shows a schedule showing various amounts of consumption corresponding to different levels of income.

Keynes's psychological law of consumption:
This law was propounded by J.M. Keynes which forms the basis of the ending consumption function. It explains the nature of propensity to consume schedule.

In the words of Keynes, "The fundamental psychological law upon which we are entitled to depend with great confidence both a prior from our knowledge of human nature and from the detailed facts of expenditure, is that men are disposed as a rule and on the average to increase their consumption as their income increases but not by as much as the increase in income."

In other words, the law implies that people have a tendency of spending less proportion of increases income on consumption because a part of income is saved.

Assumption:
This law is based on the following assumptions:

1. The psychological and institutional factors (or complexes) such as income distribution, price level, population growth, taste, preferences and fashion, etc. remain unchanged in the short period.
2. It assumes the existence of a laissez-fair capitalist economy. The law operates only in a developed and free capitalist economy. People are free to spend their increased income in such type of economy. This law is not applicable in socialist and government regulated economy.
3. It assumes the existence of normal circumstances. It implies that operation of the law is possible only under normal circumstances and not under extraordinary circumstances, like war, hyper inflation, depression, or civil war, etc.

The law is based on following propositions:

Proposition I:
When aggregate income increases, consumption expenditure also increases but by a smaller amount. It is because that as income increases, people are able to satisfy their wants side by side, so that the need to spend more on consumer goods diminishes. It does not mean that the consumption expenditure falls with the increase in income. In fact, consumption expenditure varies positively with income, but not in the same proportion in which income increases [i.e. C= f(Y) and ΔC <ΔY].

Proposition II:
The increased income will be divided in some ratio between saving and consumption (i.e. ΔY=ΔC+ ΔS). This proposition is followed from the first proposition because when the whole of increased income is not spent on consumption, the remaining is saved. Hence, consumption and saving move together.

Proposition III:
Increase in income always leads to an increase in both consumption and saving.

The three prepositions of the law can be described with the help of following schedule: 

Proposition I:
Income increases at each stage by Rs. 100 lakhs (e.g. from Rs. 0 to 100, 100 to 200 lakhs, and so on), consumption increases at each stage by Rs. 80 lakhs (e.g. from Rs. 40 to 120, 120 to 200 lakhs and so on). Here, ΔC < ΔY.Thus, when aggregate income increases, aggregate consumption also increases, but by a somewhat smaller amount.

Proposition II:
At any two consecutive periods, ΔY = 100, ΔC= 80, ΔS = 20. Hence, the increased income of Rs. 100 lakhs in each stage is divided in some ratio between consumption and saving [i.e. Rs. 80 lakhs and Rs. 20 lakhs or ΔY(100) = ΔC(80) + ΔS(20)]. Hence, increased income is divided into consumption and saving.

Proposition III:
As income increases from Rs. 0 to 100, 200, 300, 400 and 500 lakhs, consumption increases from Rs. 40 to 120, 200, 280, 360 and 440 lakhs, along with increase in saving from Rs. -40 to -20, 0 to 20, 40 and 60 lakhs, respectively. Hence, both consumption and saving increase with an increase in income.

The psychological law of consumption can also be explained with the help of following figure:

The 45° line Y = C represents income. It also indicates that at all the points lying on this line, whole of income is consumed and nothing is saved. The CC' line is the consumption line which is drawn according to the consumption function and psychological law of consumption function.

It slopes upwards to the right indicating that as income increases, consumption also increases, but at less proportion than income.

Proposition I:
When income increases from OY1 to OY2 (or Y1E1 to Y2E2) and OY2 to OY3(or Y2E2 to Y3E3), consumption also increases from E1Y1 to C2Y2 and C2Y2 to C3Y3 . Here, consumption increases at less proportion than income [i.e. S2C2 < S2E2 and S3C3 < S3E3].

Proposition II:
When income increases from OY1 to OY2 ( Y2E2) or increases by S2E2, and OY2 to OY3(Y3E3) or increases by S3E3, it is divided in some proportion between consumption S2C2 and S3C3 and saving S2C2 and E3C3 respectively [ie.  ΔY(S2E2) =  ΔC(S2C2) + ΔS(S2C2) and  ΔY(S3E3) =  ΔC(S3C3) + ΔS(E3C3)].

Proposition III:
Here, Y3E3 > Y2E2 ; C3Y3 > C2Y2; E3C3 > E2C2. This expression implies that when income increases, both consumption and saving also increase. It is also clearly shown by the widening area between the income line (i.e. 45° line) and consumption curve (or the gap between income and consumption lines is increasing).