To know whether there is a psychological law in economics or not, if there is, how it functions, you should proceed a little ahead through this content. In fact, there is a psychological law even in economics explained by John Maynard Keynes in relation to consumption behavior of human being. Before we dive into the detailed description of Keynesian psychological law of consumption, let's first understand the concept of consumption function.
1- Consumption Function
Simply, consumption is an action of using up something. In economics, consumption refers to the human behavior of spending a portion of income in the purchase of a good or service to use it up for satisfying current wants.
There are various factors that influence how much a person spends on consumption of goods or service. All other things except income, remaining the same, how much one spends on consumption depends on his disposable income. It implies that consumption of goods or service as a whole depends on a level of income. Remaining other things constant, the higher the level of income, the more will be the consumption expenditure and vice-versa. It shows that there is a relationship between income and consumption expenditure. This relationship between total consumption expenditure (C) and level of income (Y) is known as consumption function. The consumption function is also called propensity to consume and it can also be presented in a scheduler form showing various amount of consumption expenditure corresponding to different levels of income.
Symbolically it is expressed as, Y = f(C)
In a specific form it is expressed as, Y = a + bY
Where;
a = Autonomous consumption expenditure, (an intercept)
b = Marginal propensity to consume, ( a slope of the function)
C = Consumption expenditure,
Y = Current income level,
Here is an example of consumption expenditure schedule.
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In the above schedule, it is seen that even at zero income, people have spent 20 billion on consumption of goods and services from their past savings in order to remain alive. As income is generated up to 60 billion, consumption expenditure also increases up to 70 billion which is more than income by 10 billion. At income level 120 billion, it equals to consumption expenditure. Thereafter, income exceeds expenditure and the amount of saving goes up. This is how consumption expenditure functions in general.
The concept of consumption function has also been illustrated with a help of the following diagram.
In the above diagram, consumption expenditure has been measured vertically and level of income horizontally. The C=Y is the 45* angled unity line which represents equal level of consumption expenditure and income level. The curve denoted by C is the linear consumption function and its positive slope indicates that consumption is an increasing function of income. The point E is the break-even point where C = Y. In the diagram, it is seen that with an increase in income level, consumption expenditure also increases but the increase in consumption expenditure is less than that of the increase in income after the break-even point. The portion of income that is not spent on consumption expenditure, is a saving. It is equal to FH. Thus, consumption function measures not only the amount income spent on consumption but also the amount of saving.
2- Keynesian Psychological Law of Consumption
Now, let's dive into the Keynesian psychological law of consumption. For the first time, Keynes, a famous British economist of 20th century, explained a psychological tendency of human being on account of income and consumption relationship. According to him, 'The psychology of community is such that when aggregate real income increases, consumption also increases but not by so much as income.' This fundamental explanation of psychological tendency of society on account of income and consumption relationship is known as Keynesian psychological law of consumption.
To confirm his psychological law of consumption, he has presented some supporting facts to which we call basic facts or propositions of the law.
2.1- Basic Facts or Propositions of the Law
a- With the increase in income, consumption expenditure is also increases but by a smaller amount. It is because, more of our wants of consumer goods already satisfied with an increase in income and need to spend on consumer goods gradually falls. So consumption expenditure increases less than proportionately.
b- The increased income is divided into some portion between consumption expenditure and saving. It follows from the above fact, that is, when the whole of increased income is not spent on consumption, the remaining is saved. In this way consumption expenditure and saving move together.
c- With the increase in income, both consumption expenditure and saving increase than before. It is based on the above facts that when income increases, consumption expenditure also increases but by a smaller amount and it leads to increase in saving.
The above propositions have also been illustrated with a help of the following diagram.
In the above diagram, it has been shown that when income increases OP to OQ, consumption also increases from AP to BQ but the increase in consumption is less than income or BQ>AP.
When income increases from OP to OQ & OR, it is divided in some portion between consumption BQ, DR and saving BC, DE respectively as seen in the diagram.
Increase in income from OP to OQ & OR, lead to an increase in consumption from AP to BQ and BQ to DR. Similarly, saving also increases. It is seen in the diagram that DE is greater than BC.
It is clear that with an increase in income, consumption expenditure also increases but not by as much as increase in income. It is also clear that consumption and saving move together in some portion and both the saving and consumption increase with the increase in income. The widening area between the consumption curve C and C=Y line also proves it.
2.3- Assumptions of the law
There are some assumptions of this law on which it is based.
a- Normal conditions
The law is applicable only in a normal condition. In case of abnormal conditions like a war, revolution, hyperinflation etc. the law does not operate. In such a case, people may spend the whole of increased income on consumption.
b- Free market economy
The law operates in a rich free market economy where there is no government intervention and people are free to spend their income. If government regulates private enterprises, consumption expenditure, this law breaks down.
c- Constancy of psychological & institutional complexes
This law based on the assumption that the psychological and institutional complexes like income, distribution, taste, habits, social customs, prices, population growth etc. do not change in short-run and consumption depends on income alone. The constancy of these complexes is the cause of a stable consumption function.
2.4-Implications of Keynesian law or importance of consumption function
The implications of Keynesian law is as follows.
a- Invalidates Say's law of market
Say's law of market states that supply creates its own demand. Therefore, there is no general overproduction and no general unemployment but Keynesian law invalidates Say's law. He has focused that with an increase in income consumption also increases but not by as much as income increases. It implies that the whole increased income is not spent on consumption. As a result supply fails to create its own demand.
b- Need for government intervention
This law highlights the need for government intervention. The law states that consumption does not increase as much as an increase in income. In such a case, there is possibility of overproduction and unemployment. So the necessity of government intervention arises in the economy to solve the problem of overproduction and unemployment through public policy.
c- Highlights the role of investment
This law states that consumption does not increase as much as income increases and this tendency creates a gap between income and consumption which results a fall in output and employment. This gap can be fulfilled either by increasing consumption or investment but consumption function is stable in short-run. So the gap can only be filled up by increasing investment. Thus, the psychological law highlights the role of investment in Keynesian theory.
d- Unemployment equilibrium
Keynesian notion of unemployment equilibrium is also based on this psychological law. It is because, the consumers do not spend the entire income on consumption which results a deficiency in aggregate demand. Consequently, full employment equilibrium can not be reached and it occurs is an unemployment equilibrium.
e- Danger of over saving
When consumption expenditure is not equal to income level, there would be a danger of over-saving in the economy. If there is over-saving, it reduces demand which would discourage entrepreneurs to invest. Consequently investment would fall and possibility of economic instability would arise.
f- Decline in marginal efficiency of capital (MEC)
Psychological law also points towards the declining tendency of MEC. With the increase in income, consumption does not increase to the same extent so there is a decline in demand for consumer goods. This results a sufficiency in of goods in market. As a result, producers reduce in production which in turn bring a decline in demand for capital goods and also in profit margin.
g- Indicates turning points of business cycle
This law explains the turning points of business cycle. A downturn from boom starts because people do not spend their entire income on consumption. This leads to a fall in demand, increase in overproduction, unemployment etc. Conversely upturn from depression starts in the economy because when income falls, consumption expenditure also falls but by less than the fall in income. People continue to buy consumer goods even after their income falls. So when the stock of goods in the community is finished during depression, the existence consumer expenditure leads to revival. Thus, the psychological law explains the turning points of business cycle.
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