Select your language

Suggested languages for you:
Log In Start studying!
StudySmarter - The all-in-one study app.
4.8 • +11k Ratings
More than 3 Million Downloads
Free
|
|

All-in-one learning app

  • Flashcards
  • NotesNotes
  • ExplanationsExplanations
  • Study Planner
  • Textbook solutions
Start studying

Consumption Function

Save Save
Print Print
Edit Edit
Sign up to use all features for free. Sign up now
Consumption Function

Are you thinking of buying a car, tv, going shopping for clothes, or maybe even getting a haircut? Ever wonder how your consumption of goods and services impacts the economy? You would be surprised to know that your consumption actually has a "function" in economics; it's called the aggregate consumption function. It is a tool used in economics to determine various factors and impacts on the economy through consumer expenditure. What's even better is that it allows you as a consumer to get a better understanding of your consumer behavior and direct impact on the economy. So are you ready to learn about the aggregate consumption function? Let's begin!

Aggregate Consumption Function

To start off, "aggregate" refers to the total or sum of something in economic terms, for example, "aggregate output" refers to total output, "aggregate demand" and "aggregate supply" refer to the total demand and the total supply in the economy. Thus the "aggregate consumption function" shows the relationship between total disposable income and total consumer spending in the entire economy.

The aggregate Consumption Function shows the relationship between total disposable income and total consumer spending in the entire economy.

The aggregate consumption function can be depicted with the following equation:

Where:

C = Consumer spending

A = Autonomous consumption

MPC = Marginal propensity to consume

YD = Consumer disposable income

The equation above essentially summarizes the relationship between the different variables that make up the consumption function. The consumption function depicts consumer spending, "C" as a function of:

  • Autonomous consumption, "A", which is the amount that consumers would spend if there was no disposable income
  • Marginal propensity to consume, "MPC", which is the extra consumer spending that occurs for every $1 increase in disposable income, and is the slope of the consumption function equation or graph
  • Consumer disposable income, "YD", which is the income households or individuals have left to either spend or save after taxes and transfers

Consumption Function Example

The consumption function can be depicted through a schedule that shows the relationship between the various amounts of consumption expenditure for different amounts of income. This schedule can be plotted on a graph which then can be used to analyze the resulting outcomes or trends.

Aggregate Consumption Function Aggregate Consumption Function StudySmarterFigure 1. Aggregate Consumption Function, StudySmarter Originals

Figure 1. above shows the consumption function where aggregate current disposable income is found on the X-axis and aggregate consumption expenditure is found on the Y-axis. The slope of the line is MPC, i.e. when consumer income increases by $1, consumer expenditure increases by MPC. The formula for MPC is:



In addition, the consumption function can be linear or non-linear. A linear consumption function would be as seen in Figure 1 above, where. MPC will remain to be a constant value between 0 and 1 through all levels of income. A non-linear consumption function will have a changing MPC through the different levels of income. Economists have theorized that as household income increases and the needs are satisfied, then the MPC will decline and MPS (marginal propensity to save) will be increasing as income increases. The resulting effect is a non-linear consumption function with a diminishing slope.

Aggregate Consumption Function Aggregate Consumption Function StudySmarterFigure 2. Aggregate Consumption Function, StudySmarter Originals

Figure 2 above shows a non-linear consumption function with a diminishing MPC.

Factors Affecting Consumption Function

Now that we have seen a consumption function, we can next examine what causes a consumption function to shift. Since a consumption function depicts the relationship between consumer income and consumer expenditure, ceteris paribus (holding other things constant), the shift in the consumption function results from changes in other factors other than consumer income.

There are two main factors that cause a shift in the consumption function; one being a change in expected future disposable income and the other a change in aggregate wealth.

Change in expected future disposable income

The permanent income hypothesis, theorized by Milton Friedman, states that the primary factor that consumer expenditure is dependent on is the expected future income rather than the income they currently hold. For example, suppose you are expected to receive a very large bonus from your employer, but the effective date for the bonus is not for another two months. Nonetheless, you start planning a new vacation or buying new things as you are anticipating an increase in your income in the near future. Similarly, if you were to receive the news that you will be receiving a pay cut in the coming months, you would cut back on your expenditure despite your current disposable income not experiencing any change.

Change in aggregate wealth

The life cycle hypothesis states that consumer expenditure is a byproduct of accumulated wealth, which results in expenditure spread over a lifetime and is not dependent on just current disposable income. In other words, households save their current disposable income in each period of high earnings and then use their accumulated wealth in the later years of their life to both spend and live off of. For example, your retired parents who each worked for 25 years in their respective fields have invested and saved their current disposable income over the years. They were also able to pay off their mortgage, and their current disposable income is $250,000. You may have the same current disposable income as them, however, their expenditure on goods and services will be more than yours, because you would still need to save for your retirement and pay off your mortgage.

Overall, the change in expected future disposable income and the change in aggregate wealth both have the same effect on the aggregate consumption function.

Aggregate Consumption Function Aggregate Consumption Function with Increase in Disposable Income or Wealth StudySmarter

Figure 3. Aggregate Consumption Function with Increase in Disposable Income or Wealth, StudySmarter Originals

Figure 3 above shows an upward shift in the aggregate consumption function resulting from either an increase in expected future disposable income or from an increase in aggregate wealth.

Aggregate Consumption Function Aggregate Consumption Function with a Decrease in Consumer Income and Wealth StudySmarterFigure 4 - Aggregate Consumption Function with a Decrease in Consumer Income & Wealth, StudySmarter Originals

Figure 4 above shows a downward shift in the aggregate consumption function resulting from either a decrease in expected future disposable income or from a decrease in aggregate wealth.

Importance of Consumption Function

The consumption function is a great and important tool in understanding other macroeconomic indicators, variables, and factors. Through the analysis of the consumption function, we are able to better understand the business cycle, interest rates, capital stock, and money supply, just to name a few. The insights that the consumption function provides to decision-makers are key to formulating policies, making investments, and other macroeconomic decisions. You may be wondering how the consumption function does that? The consumption function provides insights into one of the greatest economic agents in any economy, the household and their decision-making and consumption behavior, which has a large impact on the economy.

Keynesian Consumption Function

The aggregate consumption function is also known as the "Keynesian Function", named after the founder John Maynard Keynes, a British economist who theorized that consumer expenditure is a function of disposable income. Prior to Keynes's revelation about the consumption function, economists theorized that consumption is a function of interest rates. Keynes's argument, on the other hand, was that consumption was a function of income, and interest could play some role but is not the sole driving factor. Given this, his theory is also known as the absolute income theory of consumption, in which he states an increase in income will result in an increase in consumption, however not by the same proportion. This is where the MPC, marginal propensity to consume, would come into play. The MPC, according to Keynes's theory, would be less than one.

The Keynesian consumption function is based on Keynes' beliefs about consumer behavior. Keynes states that consumption depends on the absolute income available in the given period. In other words, the more income a household has in a given period, the more likely it is to be spent on consumption. In addition, Keynes also emphasizes that the proportion of the increase in consumption does not equate to the proportion of the increase in income. The proportion of consumption to income is referred to as the average propensity to consume, or APC. It is calculated as consumption over disposable income.

Difference between APC & MPC

The average propensity to consume and marginal propensity to consume may sound similar, but tell us two completely different stories about the consumption function. The average propensity to consume, APC, tells us how much the economy is consuming at each given level of income, whereas the marginal propensity to consume is the slope of the aggregate consumption function and tells us the change in consumption to the change in income. It is calculated as:

Aggregate Consumption Function Aggregate Consumption Function with APC and MPC StudySmarterFigure 5. Aggregate Consumption Function with APC & MPC, StudySmarter Originals

In Figure 5 above, you can see that the slope of the consumption function, MPC, is less than the slope of the line from the origin to each point on the graph, which is the APC. Thus, with a nonlinear consumption function, both MPC and APC decline as aggregate current disposable income grows, and MPC is always less than APC at each level of disposable income.

Keynesian Multiplier

The Keynesian Multiplier is an economic concept which states that an increase in government expenditure, private investment expenditure, or private consumption expenditure will result in an increase in GDP greater than the total initial expenditure in the sectors mentioned above. However, he emphasized that the initial expenditure should be by the government, which will then be a catalyst for expenditure for the other sectors and agents in the economy.

The Keynesian multiplier is:

For example, if the MPC for a consumption function is 0.8, we can determine the multiplier by putting our MPC amount into the equation:

This says that, given an MPC of 0.8, the increase in GDP that results will be 5 times the increase in initial spending. So if the government, say, spends $1 trillion, the increase in GDP will be $5 trillion.

Consumption Function - Key takeaways

  • The Aggregate Consumption Function shows the relationship between total disposable income and total consumer spending in the entire economy.
  • The permanent income hypothesis states that the primary factor that consumer expenditure is dependent on is the expected future income rather than current income.
  • The life cycle hypothesis states that consumer expenditure is a byproduct of accumulated wealth which results in expenditure spread over a lifetime and is not dependent on just current disposable income.
  • The absolute income theory of consumption states that an increase in income will result in an increase in consumption, however not by the same proportion.
  • The Keynesian multiplier is:

Frequently Asked Questions about Consumption Function

To calculate the MPC from the consumption function, you would calculate the slope of the consumption function.

The consumption function is calculated using the following formula:


C = A + MPC X YD

Where:

        C = Consumer spending

        A = Autonomous consumption 

        MPC = Marginal propensity to consume

        YD = Consumer disposable income



The aggregate Consumption Function shows the relationship between total disposable income and total consumer spending in the entire economy. 

The marginal propensity to consume, MPC, is the slope of the consumption function.

To find the multiplier you would use the MPC from the consumption function and input it into the following formula: 1/ (1 -MPC)


Final Consumption Function Quiz

Question

How would you define the consumption function?

Show answer

Answer

The Aggregate Consumption Function shows the relationship between total disposable income and total consumer spending in the entire economy.

Show question

Question

A linear consumption function has an MPC which will be a constant value between 0 and 1 at all levels of income.

Show answer

Answer

True

Show question

Question

A non-linear consumption function will have the same MPC at different levels of income.

Show answer

Answer

False

Show question

Question

The two main factors that cause a shift in the consumption function are:


Show answer

Answer

The expected future disposable income and the change in aggregate wealth.

Show question

Question

The permanent income hypothesis states that:

Show answer

Answer

The primary factor that consumer expenditure is dependent on is the expected future income rather than current income.

Show question

Question

The life cycle hypothesis states that consumer expenditure is a byproduct of accumulated wealth which results in expenditure: 


Show answer

Answer

spread over a lifetime and is not just dependent on current disposable income

Show question

Question

The aggregate consumption function will shift ------------------------- resulting from either an increase in the expected future disposable income or from an increase in the accumulation of wealth.

Show answer

Answer

upward

Show question

Question

The aggregate consumption function will shift ------------------------- resulting from either a decrease in the expected future disposable income or from a decrease in the accumulation of wealth.

Show answer

Answer

downward

Show question

Question

John Maynard Keynes was a British economist who theorized that consumer expenditure is a function of -------------------

---------------------.


Show answer

Answer

disposable income

Show question

Question

The absolute income theory of consumption states:

Show answer

Answer

An increase in income will result in an increase in consumption, however not by the same proportion. 

Show question

Question

The proportion of expenditure to income is referred to as the:


Show answer

Answer

Average propensity to consume (APC)

Show question

Question

The marginal propensity to consume is the slope of the aggregate consumption function and tells us the change in consumption to the change in income.


Show answer

Answer

True

Show question

Question

The Keynesian Multiplier is an economic concept which states that an increase in government expenditure, private investment expenditure, or private consumption expenditure will result in an increase in GDP greater than the total expenditure.

Show answer

Answer

True

Show question

Question

If the MPC for an aggregate consumption function is 0.6, what will be the multiplier?

Show answer

Answer

2.5

Show question

Question

What is the formula for the consumption function?

Show answer

Answer

C = A + MPC x YD


Show question

Question

_____ refers to the total or sum of something in economic terms.

Show answer

Answer

Aggregate

Show question

Question

The "aggregate consumption function" shows the relationship between total disposable income and total _____ _____ in the entire economy.


Show answer

Answer

consumer spending

Show question

Question

What does "A" stand for in the aggregate consumption function?

Show answer

Answer

Autonomous consumption

Show question

Question

What does Ystand for in the aggregate consumption function?

Show answer

Answer

Disposable income

Show question

Question

What does MPC stand for in the aggregate consumption function?

Show answer

Answer

Marginal Propensity to Consume

Show question

Question

_____ is the slope of the consumption function.

Show answer

Answer

MPC

Show question

Question

To calculate MPC, you divide the change in consumption by the change in _____ _____.

Show answer

Answer

disposable income

Show question

Question

The consumption function can be non-linear.

Show answer

Answer

True

Show question

Question


Economists have theorized that as household income increases and the needs are satisfied, then the MPC will decline and MPS (marginal propensity to save) will be increasing as income increases.

Show answer

Answer

True

Show question

Question

According to the graph below, what happens to MPC as disposable income increases?

Show answer

Answer

MPC decreases

Show question

Question

The permanent income hypothesis, theorized by Milton Friedman, states that the primary factor that consumer expenditure is dependent on is the... 

Show answer

Answer

expected future income

Show question

Question

The life cycle hypothesis states that consumer expenditure is a byproduct of...

Show answer

Answer

accumulated wealth

Show question

Question

Through the analysis of the consumption function, we are able to better understand...

Show answer

Answer

the business cycle

Show question

Question

An increase in income will result in an increase in consumption, however not by the same proportion. This is known as the...

Show answer

Answer

absolute income theory of consumption

Show question

Question

Keynes emphasizes that the proportion of the increase in consumption does not equate to the proportion of the increase in income.

Show answer

Answer

True

Show question

Question

With a nonlinear consumption function, MPC is always less than APC at each level of disposable income.

Show answer

Answer

True

Show question

60%

of the users don't pass the Consumption Function quiz! Will you pass the quiz?

Start Quiz

Discover the right content for your subjects

No need to cheat if you have everything you need to succeed! Packed into one app!

Study Plan

Be perfectly prepared on time with an individual plan.

Quizzes

Test your knowledge with gamified quizzes.

Flashcards

Create and find flashcards in record time.

Notes

Create beautiful notes faster than ever before.

Study Sets

Have all your study materials in one place.

Documents

Upload unlimited documents and save them online.

Study Analytics

Identify your study strength and weaknesses.

Weekly Goals

Set individual study goals and earn points reaching them.

Smart Reminders

Stop procrastinating with our study reminders.

Rewards

Earn points, unlock badges and level up while studying.

Magic Marker

Create flashcards in notes completely automatically.

Smart Formatting

Create the most beautiful study materials using our templates.

Sign up to highlight and take notes. It’s 100% free.