.Consumption Expenditure By DR. S .M .BHUJBAL
Consumption Expenditure :Meaning: • part of income spent on goods and services by the households to satisfy their needs. • Consumption is a function of Disposable Income C = f ( YD ) :Importance: • The Largest Component of GNP ( 65-75%) • The Most Important Variable in Income Determination Models • The Most Important Factor in Determining The Level of Economic Activities
Theories of Consumption • Absolute Income Hypothesis • Relative Income Hypothesis • Permanent Income Hypothesis • Life Cycle Hypothesis
Absolute Income Hypothesis :Introduction: • Introduced by J.M.Keynes in 1936 in his famous book ‘ General Theory of Employment, Interest and Money’. • Also known as Psychological Law of Consumption • Statement: “ Men are disposed, as a rule and on average, to increase their consumption as their income increases, but not by as much as the increase in their income.”
Absolute Income Hypothesis :Properties of the Consumption Function: • Current Consumption Expenditure is a Positive Function of Current Income – C = a + bY • If income increases consumption increases, but less than proportionately. i.e. 0<MPC<1 • When Income Increases, the entire incremental income is not spent on consumption. • Incremental Income is divided into Consumption and Savings.
Absolute Income Hypothesis :Properties of the Consumption Function: • When Income is Zero, Consumption Expenditure can not be Zero. • As compared to low income people, high income people spend less proportion of their increased income on consumption. i.e. MPC declines as Income increases. • MPC (∆C/∆Y) < APC (C/Y); later rejected by the followers- (MPC=APC) • Short Run Theory
Relative Income Hypothesis :Introduction: • Introduced by Prof. James S. Duesenberryin 1949. • In his book - ‘Income, Saving and The Theory of Consumer Behaviour’. • Statement: “The Proportion of income consumed by a household depends on the level of its income in relation to the households with which it identifies itself, not on its absolute income.”
Relative income Hypothesis • Consumption of a household is linked with the income and expenditure level of the households of the comparable income groups. • Demonstration Effect (Keeping up with the Joneses): Households having a relatively lower income and living in the community of higher incomes tend to spend a higher proportion of their income than the households with higher incomes.
Relative Income Hypothesis • Ratchet Effect: Consumption does not decrease in proportion to decrease in income. • When absolute income increases, absolute consumption increases; but when absolute income decreases, the households do not allow their consumption to fall in proportion to the fall in their incomes. • Reason- Households get used to a certain standard of living in the long run and hence when their income falls, their consumption falls less than proportionately.
Permanent Income Hypothesis :Introduction: • Introduced by Milton Friedman in 1957 in his book – “A Theory of Consumption Function” • Rejected ‘Current Income Hypothesis’ • Statement: ‘It is the Permanent Income and not the Current Income, which determines the level of Current Consumption Expenditure.’
Permanent income Hypothesis • Permanent Income – ‘ The mean of all the incomes anticipated in the long run .’ • An approximation of all income anticipated from all human wealth (labour income) and non-human wealth (capital income) will give the estimation of Permanent Income. • The Permanent Income of the Current Year – Yp = rW where Yp - the permanent disposable income W - overall wealth i.e. material, financial, and human wealth- all sources of income r - the rate of return
Permanent Income Hypothesis :Basic Propositions: • Cp = kYp : Permanent Consumption is some (k) proportion of permanent income. • Ym = Yp+Ytr : Measured Income is the summation of Permanent Income and Transitory Income. • Cm = Cp+Ctr : Measured Consumption is the summation of Permanent Consumption and Transitory Consumption.
Permanent Income Hypothesis :Basic Propositions: • R1 (Ytr, Yp) = 0 – No relationship between permanent income and transitory income. • R2(Ctr, Cp) = 0 – No relationship between permanent consumption and transitory consumption. • R3(Ytr, Ctr) = 0 – No relationship between transitory consumption and transitory income.
Life Cycle Hypothesis :Introduction: • Introduced by Franko Modigliani and Albert Ando in 1963 in their book “ The Life-cycle Hypothesis of Saving: Aggregate Implications and Tests” • Statement: Individual consumption in any time period depends on i) resources available to the individual, ii) the rate of return on his capital, iii) the age of the individual. • A rational consumer plans consumption on the basis of all his resources and allocates his income to consumption over time so that he maximizes his total utility over his life time.
Life Cycle Hypothesis Basic Propositions • There is little connection between current income and current consumption. • The consumption level of a typical individual is more or less constant over his life time. • The total consumption of a typical individual depends on his current physical and financial wealth and his life time labour income. • Consumption expenditure is financed out of the life time income and accumulated wealth.
Life Cycle Hypothesis :A Life time Consumption Function: C= aWR + cYL WR = real wealth YL = labour income a = mpc (wealth income) c = mpc (labour income)
Life Cycle Hypothesis Life Time Income = Life Time Consumption YL * EL = C * N YL * EL / N = C ….. Dividing both the sides by N The proportion of income spent as consumption expenditure is proportional to the ratio EL / N. i.e. higher the proportion of earning life, higher will be the consumption expenditure
References: • ‘Macroeconomics – Theory and Policy’ – Prof. D. N. Dwiwedi - Tata McGraw- Hill Pub. • ‘Macroeconomics’ – R. Dornbusch, S. Fisher, R. Startz; Tata McGraw- Hill Pub. • ‘Macroeconomics – Theory and Policy’ – H.L. Ahuja; S. Chand Pub. • Macroeconomic Analysis – Edward Shapiro; Harcourt Brace Jovanovich Pub.