Before we proceed to a detailed description of factors affecting consumption function, let's study about the concept of average propensity to consume (APC) and marginal propensity to consume (MPC). These APC and MPC are sometimes called the technical attributes or properties of consumption function which have been described as follows.
1- Average Propensity to Consume APC
Average propensity to consume is the ratio of consumption expenditure (C) to any particular level of income (Y). In other words, it is the percentage of income spent on consumption expenditure. It can be calculated dividing consumption expenditure by the income level. APC declines with the increase in income because consumption expenditure does not increase as much as an increase in income level and vise-versa.
Symbolically APC is expressed as APC = C/Y
The concept of APC has been clarified with a help of the hypothetical data of consumption expenditure and income level as given in the following table.
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In the above table it has been shown that 80 billion has been spent on consumption out of income level equal to 100 billion where APC is equal to 0.8. Similarly, with the increase in income from 100 to 200 billion, consumption expenditure has increased from 80 to 120 billion where APC is equal to 0.6. It is clear from the above table that APC is calculated diving C by Y and it falls with an increase in income.
APC has been explained by the following diagram as well. In the diagram, Income and consumption expenditure have been measured along X and Y axis respectively.
In the diagram, CC is the consumption function where it indicates APC is equal to 0.8 at point A and 0.6 at point B. It shows that with the increase in income C also increases but APC falls. It clarifies that with an increase in income APC falls.
2- Marginal Propensity to Consume MPC
MPC is the ratio of change in consumption (ΔC) to change in income level (ΔY). It can be calculated by diving change in consumption expenditure by change in income level.
Symbolically MPC is expressed as MPC = ΔC/ΔY
The calculation of MPC has been shown in the following table.
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In the above table it has been shown that as income increases from 100 to 200 billion consumption also increases from 80 to 120 billion and there is a change in income level by 100 billion whereas consumption expenditure changes by 40 billion. It is seen that MPC is equal to 0.4. Similarly, as income again changes by 100 billion, consumption expenditure also changes by 40 where MPC is equal to 0.4.
2.1- Properties of MPC
a- MPC always positive and less that unity. It implies that percentage change in consumption is less than the percentage change in income.
b- MPC is stable in the short-run because the factors that affect consumption remain constant in short-run.
c- MPC of a poor community is higher than the rich. It is because most of the basic needs of the poor are not satisfied and they spend more on consumption with an increase in income.
3- Relation between APC and MPC
a- APC is the ratio of consumption expenditure to income level whereas MPC is the ratio of a change in consumption expenditure to the change in income level but MPC measures the rate of change in APC.
b- When as income level and consumption expenditure both increase at a constant rate APC falls and MPC remains constant but less than APC. Let's consider the following table.
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In the table, it is seen that the income level and consumption expenditure increase at a constant rate by 100 and 40 respectively. In such a situation APC falls, MPC remains constant but it is less than APC as shown in the table.
Diagrammatically, the rays from the origin to any point on CC curve gradually declines with the increase in income as shown in the above diagram. The slope of OP is greater than OQ and OQ is greater than OR all these represent APC whereas the slope of CC represents MPC.
c- When APC is stable, MPC will also be stable and equal to MPC.
The stability and equality between APC and MPC has been shown in the following table.
Diagrammatically, the slope of OC curve or MPC coincides APC as seen in the following diagram. The equality of slope of the rays from the origin to every points on OC curve also justify the stability and equality between APC and MPC.
4- Factors That Affect Consumption Functions
or
Determinants of Consumption Function
or
Factors That Influence Propensity to Consume
Consumption expenditure or human propensity to consume is determined by the following two major factors
4.1- Subjective or Internal Factors
4.2- Objective or External Factors
4.1- Subjective or Internal Factors
Subjective factors are also called endogenous factors which can be divided into individual or personal factors and business factors.
4.1.1- Individual or Personal Factors
The individual or personal factors include those factors which induce people to make a saving or refrain from spending out of their income. There are some personal factors as follows.
a- Individuals are aware of unforeseen contingency such as illness, potentiality of some kind of accidents, remain unemployed. These factors induce them to make a saving and also refrain them from spending more of their current income.
b- Individuals are also familiar with expected future needs as such the education of their children, marriage etc. All these future needs allure them to make a saving from their income and thus there is a fall in consumption expenditure.
c- People's expectation for making a future income by investing in a business or other sectors, arouses them to make a saving. So consumption expenditure is less than that of their current income. Such an expectation of people determines consumption expenditure.
d- People's personal desire to increase their social status also motivates them to accumulate wealth. This act leads them to cut in their current consumption and make a saving. This is also one of the causes that affects consumption expenditure.
e- Sometimes speculative purpose of individuals leads them to make a saving. Hence, consumption expenditure falls. So speculative purpose is also an influencing factor of consumption expenditure.
f- Some people are anxious for their heirs and children's better future and want to leave a good fortune for them. So their future anxiety toward their children makes them have a saving from current income. This causes a fall in consumption expenditure.
g- Some people have a greedy habit which refrain them from making a consumption expenditure equal to their income but make a saving. Such a habit also influences consumption expenditure.
4.1.2- Business Factors
Business factors include those factors which lead business firms to save or refrain from spending out of their income. These factors are as follows;
a- Business firms save a part of their current income to invest in new enterprises and expand in future.
b- They are induced to save for liquidity purpose so that they can face contingencies in future.
c- Sometimes some managers of business firms also make an unwanted saving more in order to prove themselves successful managers. Such a saving of managers makes a fall in business consumption and investment expenditure.
d- Most of firms save a part of their income for depreciation or replacement purpose. Such a saving causes a fall in a business consumption expenditure.
e- Debt repayment purpose of business firms sometimes compel them to make a saving from income. This also causes a fall in business consumption and investment expenditure.
All these above factors induce to make a saving and which causes a fall in propensity to consume. These are the same factors determine the level and shape of consumption function.
4.2- Objective or External Factors
Objective factors are also called external or exogeneous factors. These factors cause shift in consumption function. There are some external factors which have been given as follows.
a- Change in wages level
A change in wages level influences consumption expenditure. An increase in wage-rate results in a rise in purchasing power in general and consumption expenditure increases, which causes a shift in consumption function forward, and on its contrary, consumption function shifts backward.
b- Change in fiscal policy
A change in fiscal policy in relation to taxation and public expenditure affect consumption function. An imposition of heavy tax reduces consumption expenditure resulting a backward shift in consumption function. Conversely, tax release and increase in public expenditure, causes an uplift in consumption expenditure and which shifts consumption function forward.
c- Future expectation to change in price level
A future expectation to change in price level also affects propensity to consume. If it is expected to rise in price level, people will buy more than before and this results in an increase in consumption expenditure. If there is an expectation to fall in price level, it will lead them to cut in their consumption expenditure. Hence, consumption expenditure will fall comparatively.
d- Credit facility
A cheaper and easy credit facility arouses people to increase in consumption expenditure and shifts consumption function forward. On its contrary, consumption function shifts backward.
e- Holding of liquid assets
If people have a large amount of holdings of liquid assets, they will have a tendency to spend more on consumption in general. Consequently consumption function shifts forward and on its contrary its shifts backward.
f- Financial policy of corporations
If corporations change their policy to keep a small amount in reserve funds, share holders can get a handsome amount of bonus which enables them to increase in their consumption expenditure. On its contrary, when corporations decide to increase in reserve funds share holders get a small amount of bonus and there is a fall in consumption expenditure.
g- Income distribution
An unequal distribution of income adversely affects consumption expenditure. The poor get a small share of income and have less to spend, however, the rich get a big share of income but they have low propensity to consume. This results in fall in consumption expenditure in general. If income distribution is corrected by some policy measures, propensity to consume in general will rise.
In this way, the above mentioned subjective as well as objective factors influence the marginal propensity to consume.
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