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Chapter 3
Consumption & (Propensity to consume)
Consumption refers to the total expenditure by households on goods and
services over a given period.

Propensity to Consume describes the tendency of households to spend their

income on consumption. It has two key forms:

1. Average Propensity to Consume (APC):

APC=C/Y
Where C is total consumption, and Y is total income. It shows the
percentage of income spent on consumption.

2. Marginal Propensity to Consume (MPC):

MPC=ΔC/ΔY
Where ΔC is the change in consumption, and ΔY is the change in income.
It measures how much additional consumption occurs for each additional
unit of income.

Key relationships:

MPC+MPS=1, where MPS is the marginal propensity to save.

Higher MPC indicates a greater tendency to spend, influencing economic

growth.

Factors influencing the Tendency to Consume

Factors Influencing the Tendency to Consume:

Income level: Higher incomes may reduce MPC as savings increase.

Wealth: Wealthier individuals may consume less proportionally.

Economic conditions: Optimism or uncertainty can influence spending.

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 Government policies: Taxes or subsidies affect disposable income and
consumption patterns.

A higher tendency to consume generally stimulates economic growth, while a

lower tendency supports savings and investment.

Determinants of propensity to consume (Subjective & Objective Factors)

The determinants of propensity to consume can be categorized into
subjective factors and objective factors:

Subjective Factors
These are psychological and social influences that affect an individual's or
society's inclination to consume.

1. Psychological Attitudes:

A person's outlook toward spending versus saving, shaped by risk

tolerance and financial goals.

2. Expectations about the Future:

Optimism regarding future income and employment encourages

consumption, while pessimism reduces it.

3. Social Norms and Habits:

Cultural and societal expectations influence consumption patterns

(e.g., trends in luxury goods or frugal lifestyles).

4. Family Responsibilities:

Larger families may have a higher propensity to consume due to

greater needs.

5. Standard of Living Aspirations:

People may spend more to achieve a certain lifestyle, especially when

influenced by peers or societal benchmarks.

Objective Factors
These are measurable, economic, and institutional factors that determine the
resources available for consumption.

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 1. Income Levels:

Higher income increases consumption in absolute terms, but the

marginal propensity to consume (MPC) may decrease as income rises.

2. Wealth:

Accumulated assets, such as property or investments, increase

financial security, affecting consumption behavior.

3. Taxation:

Higher taxes reduce disposable income and consumption, while lower

taxes have the opposite effect.

4. Access to Credit:

Availability of credit encourages spending, while restrictions or high-

interest rates discourage it.

5. Distribution of Income:

A more equal income distribution tends to raise overall consumption,

as lower-income groups typically have a higher MPC.

6. Price Levels (Inflation):

Rising prices may lead to higher consumption in anticipation of further

price increases or reduce it due to decreased purchasing power.

7. Economic Policies:

Policies such as subsidies, unemployment benefits, or minimum wages

impact disposable income and consumption patterns.

8. Demographics:

Age structure of the population, such as a larger proportion of younger

or working-age individuals, can influence the overall propensity to
consume.

Both subjective and objective factors interact to shape the overall

consumption behavior in an economy.

Consumption Curve

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 The Consumption Curve represents the relationship between consumption
expenditure and disposable income. It is typically derived from Keynesian
economics and illustrates how households allocate their income between
consumption and savings.

Key Features of the Consumption Curve:

1. Shape:

The curve is upward-sloping, showing that as income increases,

consumption also rises.

The slope is less than 1, as a portion of income is saved.

2. Intercept (Autonomous Consumption):

Even at zero income, there is some level of consumption, referred to as

autonomous consumption (Ca), funded by borrowing or savings.

3. Marginal Propensity to Consume (MPC):

The slope of the curve indicates the MPC, which is the additional
consumption generated by an additional unit of income (ΔC/ΔY)

4. Equation of the Consumption Function:

C=Ca + MPC⋅DI
Where,

C = Total consumption

Ca = Autonomous consumption
MPC = Marginal propensity to consume

DI= Disposable income

Graphical Representation:
X-axis: Disposable income (DI)

Y-axis: Consumption (C)

The curve starts above the origin (due to autonomous consumption).

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 The gap between the consumption curve and the 45-degree line (C = Y)
represents savings.

If the curve is below the 45-degree line, there is saving.

If the curve is above the 45-degree line, there is dissaving (spending

exceeds income).

Factors Influencing the Consumption Curve:

1. Changes in Income: Movement along the curve.

2. Shifts in the Curve: Caused by changes in autonomous consumption or

MPC, influenced by factors like wealth, expectations, taxation, and credit
availability.

This curve is foundational in macroeconomics for understanding consumption

patterns and their role in aggregate demand.

Income category

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 Income refers to the earnings or financial resources received by individuals or
households, which influence their consumption and saving behaviors.
Different theories of income focus on its role in determining consumption.

1. Absolute Income:
Proposed by J.M Keynes in the Keynesian Consumption Theory.

Definition: In economics absolute income hypothesis concerns how a

consumer divided its disposable income between consumption and
savings. It's an economic term that simply describes the amount of money
that an individual is compensated for his work, call it wages salaries
earning take home pay its all income.

Key Points:

As income increases, consumption also increases, but not

proportionally.

Higher income leads to an increase in saving, as the marginal

propensity to consume (MPC) declines with higher income.

2. Relative Income:
Introduced by James Duesenberry in the Relative Income Hypothesis. /
Demonstration Effect.

Definition: Consumption of an individual is not the function of an absolute

income, but of his relative position in the income distribution in a society.

Key Points:

Individuals compare their income and consumption levels to those of

their peers.

Social and cultural factors influence spending to maintain a similar

lifestyle, even at the cost of savings.

This theory explains why consumption remains relatively stable

despite short-term changes in income.

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 3. Permanent Income:
Developed by Milton Friedman in the Permanent Income Hypothesis.

Definition: Consumption is based on an individual’s long-term average

income (permanent income) rather than current income (transitory
income).

Key Points:

People smooth consumption over time, adjusting to temporary income

changes minimally.

Permanent income includes expected future earnings, influencing

consumption decisions today.

Transitory changes in income (e.g., bonuses or losses) have a smaller

impact on consumption.

Summary Table:
Concept Focus Consumption Behavior

Current disposable Direct but diminishing relationship with

Absolute Income
income consumption

Income compared to Social comparison influences

Relative Income
societal peers consumption more than saving

Permanent Long-term average Stable consumption; reacts less to

Income expected income temporary income changes

These theories help explain different aspects of income’s impact on

consumption patterns.

What is investment ? Category of investment?

Investment refers to the allocation of money or resources into assets,
projects, or ventures with the expectation of generating future returns or
profits.

Categories of Investment:

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 1. Planned Investment: Investment made deliberately by businesses or
governments based on expectations about the future.

2. Unplanned Investment: Investments that occur unexpectedly, such as

inventory increases due to unanticipated demand.

3. Autonomous/Income Inelastic Investment: Investments that are

independent of income or output levels. These are often driven by factors
like technological advancements, policy changes, or long-term strategic
goals.

4. Induced Investment/Income Elastic Investment: Investments that depend

on income or output levels. When income rises, businesses are more likely
to invest to take advantage of increased demand.

5. Private Investment: Investments made by private individuals or

companies, typically seeking profit or growth.

6. Public Investment: Investments made by the government or public sector,

aimed at enhancing public welfare, infrastructure, or services.

Factor affecting investment (বই এর সাথে মিলিয়ে দেখিও)

The factors affecting investment include:

1. Marginal Efficiency of Capital (MEC): The expected rate of return on an

additional unit of capital. Higher MEC encourages investment as firms
expect higher returns from their investments.

2. Rate of Interest (i): The cost of borrowing funds. Higher interest rates
discourage investment as the cost of financing increases, while lower
rates make borrowing cheaper and more attractive.

3. Business Expectations: Expectations about future economic conditions,

market demand, and profitability influence investment decisions. Optimism
about future growth leads to higher investment.

4. Government Policies: Fiscal policies (tax incentives, subsidies) and

monetary policies (interest rate adjustments) can influence investment
levels. Supportive policies can boost investment.

5. Technological Advancements: New technologies create opportunities for

businesses to invest in more efficient and profitable production methods,

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 leading to increased investment.

6. Inflation: High inflation may deter investment due to uncertainty and the
potential for eroded returns, while low and stable inflation fosters
confidence in investments.

7. Availability of Credit: Easy access to credit increases investment

opportunities for businesses by enabling them to finance projects more
easily.

8. Market Size and Growth: A larger and growing market encourages

investment, as businesses anticipate higher demand for their products or
services.

9. Political Stability: Stable political environments reduce uncertainty and

encourage investment, as investors seek predictability and safety for their
capital.

Life Cycle theory of Consumption

The Life Cycle Theory of Consumption, developed by economists Franco
Modigliani and Richard Brumberg, suggests that individuals plan their
consumption and savings behavior over their lifetime with the goal of
maintaining a stable standard of living. The theory is based on the following
key ideas:

1. Consumption Smoothing: People prefer a stable consumption pattern

throughout their life, even though their income may vary significantly at
different stages (e.g., lower income when young, higher income during
working years, and lower income after retirement).

2. Life Stages:

Youth (Early Life): Individuals typically earn less than they consume
and borrow to maintain consumption levels.

Working Age (Middle Life): Individuals earn more than they consume,
allowing them to save for retirement.

Retirement (Old Age): Consumption continues at the same level as

during the working years, funded by savings accumulated during the
middle age.

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 3. Intertemporal Choice: The theory assumes that individuals make
consumption and saving decisions based on a trade-off between present
and future consumption, taking into account factors like income and
expected future needs.

4. Wealth Accumulation: Individuals accumulate wealth during their working

years to fund consumption during retirement, relying on savings,
investments, and pension funds.

The theory highlights that saving behavior is driven by long-term planning,

with consumption decisions made in anticipation of future income and needs.

Visual representation of life cycle theory of consumption.

The life-cycle theory of consumption is an economic theory that explains how
people make consumption decisions over their lifetime. It suggests that
individuals plan their consumption patterns to smooth their consumption over
their entire life, even when their income fluctuates.

Key Concepts

1. Income Fluctuations: People's income typically varies throughout their

lives. It's low when they are young and starting their careers, increases
during their working years, and then declines after retirement.

2. Consumption Smoothing: The life-cycle theory argues that individuals

prefer a stable level of consumption rather than large fluctuations. They
aim to maintain a relatively constant standard of living regardless of their
current income.

3. Saving and Dissaving: To achieve this consumption smoothing, individuals

save during their peak earning years when their income exceeds their
desired consumption level. This accumulated savings then provide a buffer
during periods of lower income, such as retirement or unemployment.

Stages of Life

Early Life: Individuals may borrow or dissave (spend more than they earn)
to finance education or establish themselves in their careers.

Working Years: As income rises, individuals save a portion of their

earnings to build up a nest egg for retirement.

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 Retirement: Individuals rely on their accumulated savings and possibly
government pensions to maintain their desired consumption level.

Visual Representation:

Lifecycle hypothesis graph

The graph illustrates the life-cycle theory. The income curve shows how
income typically changes over a person's lifetime. The saving and dissaving
phases are represented by the areas where the consumption line is above and
below the income curve, respectively.

Limitations

Uncertainty: The life-cycle theory assumes that individuals can accurately

predict their future income and lifespan, which may not always be the
case.

Other Factors: The theory may not fully account for other factors that
influence consumption, such as wealth, interest rates, and psychological
biases.

Despite its limitations, the life-cycle theory provides a valuable framework for
understanding how individuals make consumption decisions over their lifetime
and has important implications for economic policy and personal financial
planning.

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