Q: Critically examine different Consumption theories?

Ans:
There are different Consumption Theories presented by different economist:
Consumption Theories:
John Maynard Keynes: consumption and current income
Irving Fisher and Intertemporal Choice
Franco Modigliani: the Life-Cycle Hypothesis
Milton Friedman: the Permanent Income Hypothesis
Robert Hall: the Random-Walk Hypothesis
Keynesian Consumption Function
When Keynesian Cross model and the IS-LM model is studied, we did introduce the Keynesian
Consumption Function:
C = C0 + cY
C = consumption expenditure
Y = disposable income
C = autonomous consumption (intercept of the line)
c = marginal propensity to consume (slope of the line)
The main features of that function are:
a) The only determinant of current aggregate consumption is current income;
b) The Marginal Propensity to Consume (MPC) is 0 < c < 1;
c) The Average Propensity to Consume (APC) Ct/Yt = Co/Yt + c is decreasing with income;
The properties a), b) and c) are called the Keynes Conjectures.
Property b) means that only a part of current income is consumed and so a proportion 1-c
becomes saving.
Property c) says that as income increases (meaning consumers become richer) consumers will
save a larger fraction of income.
Graphically the Keynes Consumption function looks like:


The slope of any ray connecting zero with a point on the consumption function is the Average
Propensity to Consume. As income increases a ray connecting zero with a point on the
production function becomes flatter meaning that the slope is decreasing.
I s the Keynesian Consumption function a good representation of consumers behavior?
By looking at early empirical evidence (in the 30s and 40s) we had:
1) Cross-sectional evidence:
this was evidence coming from surveys about households at a given point of time. For example
a sample of 1000 consumers in 1934. The results from this evidence were:
a) Richer households consumed more than poorer ones MPC > 0
b) Richer households saved more than poorer ones MPC < 1.
c) Richer households saved larger fractions of their income APC asY .
d). The correlation between current income and current consumption was found to be very
strong (this was found during the Great Depression).
Therefore according to this evidence it seemed that the Keynesian Consumption Function was a
good representation of consumers behaviour.
2) Time series evidence:
in 40s new pieces of evidence about aggregate consumptions were found by Simon Kuznets (a
Nobel prize winner). He created a set of data from the US national accounts from 1869 to the
1940s on aggregate Y and C. According to the Keynes Consumption Function aggregate
consumption should grow more slowly than income. This is because as Y increases, C also
increases but proportionately less than income. Moreover as income increases APC should
decrease. Kuznets found that the ratio C/Y was very stable in long time series data. This implies
that C grew at the same rate as income and as income increased APC did not fall.
Therefore we have two different pieces of evidence giving very different results.
The difference between the two was that the first one was cross-sectional in detail (they looked at
a snapshot of the economy at a point)
whereas Kuznetss study was of a time series nature (it looked at the economy over many points
in time).
So the evidence seemed to indicate that there were two consumption functions:
a short-run Consumption function which seemed to conform to Keyness conjectures and a
longrun consumption function in which the APC was basically constant. This is known as the
Consumption Puzzle.






Psychological Law of Consumption By J.M Keynes:

J.M. Keynes, in his book General Theory analyzed the consumption behavior of the
community on the basis of human psychology. He propounded a law which is known
as Psychological Law of Consumption.

Statement:

According to this law:

"The household sector spends a major part of its income on the purchase of consumer goods and
services such as food, clothing, medicines, shelter etc., for personal satisfaction. The expenditure
on consumption (C) is the largest component of aggregate expenditure. Whatever is not
consumed out of disposable income is by definition called saving (S)".
Assumptions:
(a) Habits of people regarding spending do not change or that the propensity to consume
remains the same or stable.
(b) The economic conditions remain normal. There is no hyper-inflation or war or other
abnormal conditions.
(c) The economy is a free-market economy. There is no government intervention.
(d) The important characteristic of the slope of consumption function is that the marginal
propensity to consume (mpc) will be less than unity. This results in low-consumption
and high-saving economy.
Formula:
Disposable Income = Consumption + Saving
I = C + S
Explanation:

According to Keynes, the level of consumption in a community depends upon the level of
disposable income. As income increases, consumption also increases but it increases not as fast
as income i.e., it increases at a diminishing rate. This relationship between consumption and
disposable income is called consumption function.

In the words of Keynes:

Men are disposable as a rule and on the average to increases their consumption as their
income increases, but hot by as much as the increases in their income.

Properties of Consumption Behavior of Community:

The psychological law of consumption brings out the following properties of the consumption
behavior of the community:

(i) The level of consumption is directly functionally related to the level of disposable income =
C = f(y)

(ii) With the rise in the level of income, the consumption level also rises, but at a decreasing rate
= C < y

(iii) As the level of income increases, the households devote a part of the increase saving.
Symbolically: Y = C + S

The Keynesian consumption function is now explained with the help of schedule and a curve.




Schedule:( in billion)
Disposable
Income (Y)
Consumption (C) Saving (S) APC (C/Y) MPC (C/Y)
0 50 -50
100 100 0 1.00 0.5
200 150 50 0.75 0.5
300 200 100 0.67 0.5

In the schedule, it is shown that as the nations disposable income increases, the aggregate
consumption at various levels of income also increases but at a decreasing rate.

The same data is now shown in graph 30.1 below:

Diagram/Graph:



Following are the observations about the functional relationship between the national disposable
income and the economys aggregate expenditure.

(i) At every point on the 45
0
line OY, a vertical line drawn to the income axis is at the same
distance from the origin as a horizontal line drawn to the consumption axis. The 45
0
line thus is
the line along which expenditure equals real income.

(ii) The consumption function is represented by consumption line (C). The consumption line C is
positively sloped indicating that as the disposable income increases, the expenditure in the
economy also increases.

(iii) The consumption line (C) intercepts at Y axis showing negative saving of $50 billion during
a short period.

(iv) At point B the consumption line (C) intersects the 45
0
helping line (OY) saving. At point B,
consumption equals disposable income and there is zero saving. B is called the break even point.

(v) Left to the point B, the consumption line C is above the income line Y. It indicates negative
saving.

(vi) Right to the point B, the consumption line C is below the income line Y. It denotes positive
savings.
Implications:
According to Keynesian theory, the mpc is less than unity, which brings out the following
implications:
(a) Since consumption largely depends on income and consumption function is more or less
stable, it is necessary to increase investment fill the gap of declining consumption as income
increases. If this is not done, the increased output will not be profitable.
(b) When the income increases, and the consumption are not increased, there is a danger of
over-production. The government will have to step in to remedy the situation. Therefore, the
policy of laissez-faire will not work here.
(c) I f the consumption is not increased, the marginal efficiency of capital (MEC) will
diminish. The demand for capital will also diminish, and all the economic progress will come to
a standstill.
(d) Keynes Law explains the turning points in the business cycle. When the trade cycle has
reached the highest point of prosperity, income has gone up. But since consumption does not
correspondingly go up, the downward cycle starts, for demand has lagged behind. In the same
manner, when the business cycle has touched the lowest point, the cycle starts upwards, because
consumption cannot be diminished beyond a certain point. This is due to the stability of mpc.
(e) Since the MPC is less than unity, this law explains the over-saving gap. As income goes on
increasing, consumption does not increase as much. Hence saving process proceeds
cumulatively and there arises a danger of over-saving.
(f) This law also explains the unique nature of income generation. If money is injected into
the economic system, it will increase consumption but to a smaller extent than increase in
income. This again is due to the fact that consumption does not increase along with increase in
income.
Summing up, the relationship between consumption and disposable income is referred to as
consumption function. A consumption function tells how much households plan to consume at
various levels of disposable income.

Absolute Income Theory of Consumption
Drift Theory of Consumption
On the first attempts to reconcile the short run and long run consumption functions was by Arhur
Smithies and J ames Tobin. They tested Keynes absolute income hypothesis in separate studies
and came to the conclusion that the short run relationship between consumption and income is
non-proportional but the time series data show the long run relationship to be proportional.

The latter consumption income behavior results through an upward shift or drift in the short run
non proportional consumption function due to factors other than income.
Smithies and Tobin discuss the following factors:
1. Asset Holdings
Tobin introduced asset holdings in the budget studies of negro and white families to test
this hypothesis. He came to the conclusion that the increase in the asset holdings of
families tends to increase their propensity to consume thereby leading to an upward shift
in their consumption function.
2. New Products
Since the end of the second world war, a variety of new household consumer goods have
come into existence at a rapid rate. The introduction of new products tends to shift the
consumption function upward.
3. Urbanisation
Since the post world war there has been an increased tendency toward urbanisation. This
movement of population from rural to urban areas has tended to shift the consumption
function upward for the reason that the propensity to consume of the urban wage earners
is higher than that of the farm workers.
4. Age Distribution
There has been a continuous increase in the percentage of old people in the total
population over the long run. Though the old people do not earn but they consume
commodities. Consequently, the increase in their numbers has tended to shift the
consumption function upward.
5. Decline in Saving Motive
The growth of social security system makes automatic saving and guarantees income
during illness. Redundancy disability and old age has increased the propensity to
consume.
6. Consumer Credit
The increasing availability and convenience of short term consumer credit shifts the
consumption function upward. The greater case of buying consumer goods with credit
cards, debit cards, use of ATMs and cheques and availability of installment buying
causes an upward shift in the consumption function.
7. Expectation of income increasing
Average real wages of workers have increased and they expect them to rise in the future.
These cause an upward shift in the consumption function. Those who expect higher
future earnings tend to reduce their savings or even borrow to increase their present
consumption.

The consumption drift theory is explained in the diagram 3 where CL is the long run
consumption function which shows the proportional relationship between consumption
and income as we move along it. CS1 and CS2 are the short run consumption functions
which cut the long run consumption function CL at points A and B. but due to the factors
mentioned above, they tend to drift upward from point A to point B along the curve CL
curve.
Each point such as A and B on the CL curve represents an average of all the values of
factors included in the corresponding short run functions, CS1 and CS2 respectively and
long run function, CL connecting all the average values. But the movement along the
dotted portion of the short run consumption functions, CS1 and CS2 would cause
consumption not to increase in proportion to the increase in income.
Its Criticisms
The great merit of this theory is that it lays stress on factors other than in income which affect the
consumer behavior. In this sense, it represents a major advance in the theory of the consumption
function. However it has its short comings.
1. The theory does not tell the rate of upward drift along the CL curve. It appears to be a
matter of chance.
2. It is just a coincidence if the factors explained above cause the consumption function to
increase proportionately with increase in income so that the average of the values in the
short run consumption function equals a fixed proportion of income.
3. According to Duesenberry all the factors mentioned as causes of the upward shift are not
likely to have sufficient force to change the consumption savings relationship to such an
extent as to cause the drift.
4. Duesenberry also points out that many of the factors such as decline in saving motive
would lead to a secular fall in the consumption function. Such saving plans as life
insurance and pension programs tend to increase savings and decrease the consumption
function. Moreover, people want more supplementary savings to meet post retirement
needs which tend to decrease their current consumption.

Relative Income Hypothesis Theory by Dusenberry:
The Relative Income Hypothesis was first introduced by Dorothy Brady and Ross Friedman. It
states that the consumption expenditure does not depend on the absolute level of income but
instead the relative level of income.
According to Dusenberry, there is a strong tendency for the people to emulate and imitate the
consumption pattern of their neighbours. This is the demonstration effect.
Duesenberry states that
(1) Every individuals consumption behaviour is not independent but interdependent of the
behaviour of every other individual and
(2) That consumption relations are irreversible and not reversible in time.
Statement of the Theory:
In formulating theory of the consumption function, Duesenberry writes
A real understanding of the problem of consumer behavior must begin with a full recognition
of the social character of consumption patterns. By the Social character of consumption
patterns he means the tendency in human beings not only to keep up with the Joneses but
also to surpass the Joneses. Joneses refers to rich neighbors.
The relative income hypothesis also tells us that the level of consumption spending is
determined by the households level of current income relative to the highest level of income
earned previously. People are then reluctant to revert to the previous low level of
consumption. This is ratchet effect.
The relative income theory states that if current and peak incomes grow together changes in
consumption are always proportional to change in income. That is, when the current income
rises proportionally with peak income, the APC remains constant.

Permanent Income Hypothesis by Miltom Friedman
Due to Milton Friedman (1957), The basic idea is that peoples income has a random element
to it and also a known element to it and that people try to smooth the random part.
Friedman draws a distinction between permanent consumption and transitory
consumption. Permanent consumption stands for that part of consumer expenditure which the
consumer regards as permanent and the rest is transitory.
Distinction can also be made between durable and non-durable consumer goods. Durable
consumption is concerned with purchasing capital assets and in the case of non-durable goods
the act of consumption destroys the good.
Ordinary consumer expenditure relates to non-durable consumption, i.e., consumption of goods
which are quickly used in consumption. These are theflow items since a flow of them is being
continuously consumed. On the other hand, durable consumption, which relates to the purchase
of capital assets, is an act of investment. These are stock items.
According to Friedman, permanent consumption (Cp) is a function of:
(i) Rate of interest,
(ii) Rates of consumers income from property and his personal effort, i.e., human
and non-human wealth, and
(iii) Consumers preference for immediate consumption multiplied by permanent
income (Yp).
The permanent income theory really emphasises the important role of capital assets or wealth in
determining the size of consumption. It shows how both income and consumption are closely
linked with the consumers wealth. It is capital and wealth, which affects the level of
consumption rather than consumers income.

Define Current I ncome Y as:
Y = Y P + Y T
YP = Permanent Income: this represents the long run (average) income which people expect to
persist into the future.

Y T = Transitory I ncome: this represents temporary deviations from average income.
This is the random part of income that is unexpected. It can be positive or negative;

Example:
suppose that you are working and receive an annual salary of 30000. Suppose that you expect to
get that salary every year in the future. Then 30000 represents the permanent part of your
income and you expect to get 30000 every year also in the future. However assume that this
year, since you have been very productive, you receive a bonus of 5000. This bonus represents
a transitory income since you do not expect to get it every year from now on.

Fishers Two Period Model of Consumption

The Keynesian Consumption Function is not microfounded. It is not derived from a model of
optimal behaviour of consumers. Here we look at microfoundations of aggregate consumption
and see if the Keynesian Consumption Function is consistent with a microfounded analysis. The
following analysis is due to Irving Fisher (the one of the Fisher Effect). The model is in practice
very similar to the one we did for Ricardian Equivalence.

Consider a representative consumer (there are many consumers but they are all equal) that lives
for only two periods. There is no government. The consumer is rational and forward looking.
Meaning: he maximises his own utility over his lifetime subject to his lifetime budget constraint
and in deciding what to do today he takes into account what it will happen in the future. The
consumer can lend and borrow at the real interest rate r.

The budget constraint in period 1 is:
C1 + S1 = Y1
Where C is consumption, S denotes saving and Y is income. In period 2 the budget
Constraint is:
C2 = Y 2+ (1+ r) S1
Obviously in period 2 there is no saving since the consumer dies and so it will consume all his
income in period 2.
Intertemporal budget constraint of our consumer is:

Graphically the intertemporal budget constraint looks like:

On the vertical axis we put consumption in period 2 and on the horizontal axis the consumption
in period 1. The intertemporal budget line in the graph shows all combinations of C1 and C2 that
just exhaust the consumers resources. The point C1 = Y1 and C2 = Y2 showed in the graph is
always feasible and is on the budget line. Our consumer can move along the budget line by
saving and borrowing. The intertemporal budget constraint implies a trade-off between
consumption in period 1 and in period 2. If our consumer wants to consume more in period 2
compared to C2 = Y2, he must consume less in period 1 in order to save.
The Life Cycle Hypothesis (LCH) of Consumption
The Keynesian Consumption Function while able to explain aggregate consumption of an
economy at a point in time was not able to explain it over time. This is what we called
consumption puzzle.
Background:
In the early 1950s, Franco Modigliani and his student, Richard Brumberg, developed a theory
based on the observation that people make consumption decisions based both on the resources
available to them over their lifetime and on which is their current stage of life.
Therefore there was the need to have a theory to explain the behavior over time of the aggregate
consumption. Two theories were developed at about the same time, one theory was proposed by
Franco Modigliani (Nobel Prize in economics) called the Life Cycle Hypothesis.
Modigliani and Brumberg observed that individuals build up assets at the initial stages of their
working lives. Later on during retirement, they make use of their stock of assets. The working
people save up for their post-retirement lives and alter their consumption patterns according to
their needs at different stages of their lives.
Extending the idea of the Fishers model the Life Cycle model says that it is not only income in
the current period that affected peoples observed consumption choices, but also income they
expected in the future. The Life Cycle Hypothesis is that the income of people varies in a known
way (systematic way) over peoples lives and that people use savings to move income from high-
income periods to low-income periods in order to smooth consumption over their lifetime.
Basic Assumptions of the Life Cycle Hypothesis

a) Perfect Knowledge of Lifetime: individuals know with certainty how much they are going to
live and when they are going to die;
b) Uniform Consumption: individuals prefer to have a constant stream of consumption over
their lifetime;
c) Zero Bequests: individuals do not die with positive income. They consume all their
accumulated saving;
d) Zero Real I nterest Rate: this is a simplifying assumption;
e) Ability to Calculate Future I ncome: individuals are able to guess correctly what their future
income is going to be;
A Basic Life Cycle Model
Consider a representative consumer (many consumers all equal) that is going to live
until time T. Denote with:
- W the initial wealth of the consumer (this includes financial and real assets).
- Y the constant annual income that the consumer is going to earn until retirement.
- R is the number years until retirement.
The Lifetime Resources of the consumer is:
W + RY ---------------------- Equation (1)
Equation (1) is the discounted lifetime resources (remember that r = 0 by assumption). To
achieve constant consumption over time our consumer divides lifetime resources equally over
time


Since over time aggregate wealth and aggregate income tend to grow together (given 12 the
assumption of consumption smoothing if income increases, consumption remains constant and
so saving (and wealth) will grow proportionally to income) then APC should remain stable over
time.
Graphically, an example of a consumption profile of an individual under the Life Cycle
hypothesis looks like:



ROBERT HALL AND THE RANDOM-WALK HYPOTHESIS

Robert Hall was first to derive the implications of rational expectations for consumption. He
showed that if the permanent-income hypothesis is correct and if consumers have rational
expectations, then changes in consumption over time should be unpredictable. When changes
in a variable are unpredictable, the variable is said to follow a random walk.

According to Hall, the combination of the permanent-income hypothesis and rational
expectations implies that consumption follows a random walk.