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Abel197

THEORIES OF CONSUMPTION
(1) Absolute Income Hypothesis - Keynes
“the fundamental psychological law, …
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He also proposed that consumption income relationship is non- proportional
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Since Keynes lays stress on the absolute size
of income as a determinant of consumption, his theory of consumption is also known as
absolute income hypothesis
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Consumption is a stable function of real disposable income
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The consumption income relationship is reversible
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Consumption pattern of one group of consumers is quite independent of that of

others
4
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b = the Marginal Propensity to Consume
'MPC' andYd = Current Disposable Income
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0 < MPC < 1
2
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(APC = C/Y ) =
a/Y + b
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Income is the main determinant of consumption
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Figure showing MPC
Figure showing APC
C

C

C = a + bY
dC/dY

C = a + bY
APC = a/Y +b

MPC is slope of Csn function

slope of APC

a
Y
(explain the graph)

Y

Several theoretical implications can be developed by ratio of consumption expenditure to the
level of disposable income, that is APC
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Low consumption means inadequate demand for goods and services, which would
probably results in another depression
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However, as contrary to this prediction, the
economy was not thrown into another depression after the world war II
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He constructed
new aggregate data on consumption and income dating back to 1869
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(that is constant APC)
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The failure of secular
stagnation hypothesis and the findings of Kuznets both indicated that the APC is fairly
constant over long periods of time
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We shall study below how modern
theories of consumption such as Duesenberry’s relative income theory of consumption life
cycle hypothesis and Friedman’s permanent income theory succeed in resolving this puzzle
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His
theory is therefore called Relative Income Theory of Consumption
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Further, a famous American
economist Friedman has advanced a hypothesis regarding consumption behaviour, called
permanent income hypothesis, according to which consumption of an individual depends on
permanent income rather than current level of income
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S
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Another important departure made by Duesenberry from
Keynes’s consumption theory is that, according to him, the consumption of a person does not
depend on his current income but on certain previously reached income level
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Accordingly, if a family’s income increases but its relative position
on the income scale remains unchanged because the incomes of other families with whom it
identifies have risen at the same rate, its division of income between consumption and saving
will remain unchanged
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Hence, RIH concludes that consumption
income relationship is proportional
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See
graph below
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Suppose its
income level rises to Y2
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e
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This implies that the consumption
expenditure of family A has risen in the same proportion as its income with the result that its
average propensity to consume remains constant
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This again means that the proportion of income devoted to
consumption by family B (i
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its APC) remains constant as there is increase in its absolute
income
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But Duesenberry’s relative income hypothesis suggests
that as income increases consumption function curves shifts above so that average propensity
to consume remains constant
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Therefore, the theory leads to the conclusion that the basic
relationship between consumption and income is proportional, that is, APC is constant
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People have a tendency to imitative or copy the living pattern of richer
section
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A family with any
given level of income will typically spend more on consumption if it lives in a community in
which that income is a relatively low one than if it lives in a community in which that income
is a relative higher one
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For example, the recent studies of household expenditure made in India reveal that the
families with a given income, say Rs
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The higher propensity to consume of families living in urban areas is due to the
working of demonstration effect where families with relatively higher income reside whose
higher consumption standards tempt others in lower income brackets to consume more
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This is
called Ratchet effect
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This is often called a ratchet effect
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This is partly
due to the demonstration effect explained above
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Consumption expenditure may fall as the absolute level of income declines but not in
proportion to the fall in income
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It explains the tendency for an economy’s consumption expenditure not to
fall as much as the fall in income
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The ratchet effect is represented in the graph below
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Now suppose that the economy

experiences an economic depression and disposable income falls to Yo
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(3) The Permanent Income Hypothesis (PIH) - Milton Friedman

Milton Friedman hypothesis that consumption is not based on current income but rather on
what the household considered to be its future expected or anticipated income
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This theory also
maintains that the basic relationship between consumption and income is proportional but the
relationship is between permanent consumption and permanent income
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This is referred to by him as the permanent income
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Permanent income has been defined by
Friedman as “the amount which the consumer unit could consume (or believes that it could)
while maintaining its wealth intact”
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The deviation between measured
income and permanent income are called the transitory income which may be either positive
or negative
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Ym = Yp + Yt
Similarly according to Milton Friedman consumption is constituted of two components permanent consumption (Cp) and transitory consumption (Ct)
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“It is to be interpreted as the mean income regarded as permanent by the
consumer unit in question which in turn depends on its horizon and farsightedness
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It may be noted that permanent income or expected long-term average income is earned from
both “human and non-human wealth”
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This is generally referred to as labour income
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It is worth noting that Friedman regards consumer durables such as cars,
refrigerators, air conditioners, television sets as part of households’ non-human wealth
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A family’s measured income in any particular year may be larger or smaller than its
permanent income, depending on the sum of positive and negative transitory income
components
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Relationship between Consumption and Permanent Income
According to permanent income hypothesis, Friedman thinks that consumption is
proportional to permanent income
CP=kYP
where
YP is the permanent income
CP is the permanent consumption
k is the proportion of permanent income that is consumed
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Thus rewriting the consumption function based on Friedman’s permanent income hypothesis
we have
CP =k (i, w, u) YP

Friedman’s permanent income hypothesis is illustrated in Figure below
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This long-run consumption function shows the proportional
relationship between consumption and income and is a straight line passing through the
origin which implies that APC is constant and is equal to MPC
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Thus
1
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2
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rytct = 0 - there is no correlation between transitory income and transitory
consumption
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It amounts to saying that in a period in which a
family’s measured income contains a negative transitory component, it will not result in a

Sanathanan velluva ( for private circulation among UG students of Devagiri college only)

fall in the consumption of that family
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In short, unexpected
increases or decreases in income do not produce corresponding increases or decreases in
consumption instead, they produce equivalent changes in savings
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Many economists have
questioned this argument
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S
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The critics says
that the lucky winner does not run to the savings bank but to the tavern and the victim of theft
does not cut his coat according to his cloth
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It implies that the APS of families at all levels
of income will be the same
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Criticisms
Firstly the assumption that permanent and transitory income components are not correlated
has been criticized as it is not based on facts
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Despite these weakness Economists points out it can be fairly said that evidences support this
theory and Friedman’s formulation has reshaped and redirected much of the research on
consumption function
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The LCH
says that income varies systematically over the phases of the consumer’s “life
cycle,”and saving allows the consumer to achieve smooth consumption
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Brumberg and F
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It is an attempt made by these economists to
reconcile the long run proportional and short – run cyclical consumption behaviors of the
people
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The aim of the consumer is
to maximize his utility over his life time
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The life cycle hypothesis is based on the following assumption
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There is no change in the price level during the life span of an individual
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The rate of interest remains stable
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The individual consumer does not inherit any asset and him net assets are the result
of his own saving
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In the middle age
people are at the peak of their earning capacity, and save more to pay off their earlier debts
and to provide for their retirement
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After retirement he again dissaves, that is, consumes more than his income
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Life cycle hypothesis has been depicted in Fig
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It is assumed that a typical individual
die at the age of 75 years
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It will be noticed that upto the age of 25 years his income, though increasing, is less than his
consumption, that is, he will be dissaving the early years of his working life
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Beyond the age of 25 or point A on the income and consumption curves and upto the age of
65 years his income exceeds his consumption, that is, he will be saving during this period of
his working life
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It will be observed that beyond point B (that is, after retirement at 65 years) his current
income falls short of his consumption and therefore he once again dissaves
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The shaded area AHB will be equal to the two areas of dissavings, CYA + BC’Y’
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He has planned his consumption expenditure over the
years that his net savings at the time of death are zero
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Criticisms
Although life cycle theory has provided an explanation of various puzzles about consumption
function, it is not without critic
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Critics says that the possession of this vision on the part of households sounds unrealistic
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