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Theories of Consumption

Here students are introduced to the various theories of investment. The students 
are equipped with a clear analysis of consumption expenditure theories. The 
following theories are simplified for easy understanding of the student; absolute 
income hypothesis, relative income hypothesis, permanent income hypothesis, 
and life cycle income hypothesis.
At the end of this module student should be able to;
i. Understand the theories of consumption
ii. Differentiate among the consumption theories 
iii. Compare the theories
iv. Determine those factors that influence consumption theoretically.

Theories of the Consumption Function

Keynes in his general theory postulated the aggregate current disposal income. 
The relation between consumption and income is based on his psychological law 
of consumption which states that when income increases, consumption 
expenditure also increases but by a smaller amount. In other words, the 
consumption expenditure increases (or decreases) with increase or (decrease) in 
income but not proportionally. This notion of disproportional consumption 
functions implies that in the short-run average and marginal propensities to 
consume do not coincide. Rather MPC < APC, and that the marginal propensity 
to consume is positive but less than unity (0<MPC<1). Lastly, the Keynesian 
consumption function is assumed to be stable both in the short-run and long-run

Self Assessment Exercise
i. Explain what you understand by Keynes consumption function .


Keynes‘s consumption income relationship is known as the absolute income 
hypothesis which states that when income increases, consumption also increases 
but less than the increase in income, and vice- versa. This means that 
consumption income relationship is non proportional. James Tobins and Arthur 
Smithies tested this hypothesis in separate studies and came to the conclusion 
that the short run relationship between the consumption and income is non�proportional but the time- series data show the long run 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. These factors are discussed as under.
First, professor Tobin introduced asset holding 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. 
Second, since the end of the Second World War, a verity of new household 
consumer goods has come into existence at a rapid rate. The introduction of such 
essential tends to shift the consumption function upward. Third, since the post�war period, there has been an increase in tendency toward urbanization. This 
movement of population from rural to urban areas has tended to shift the 
consumption function upward because the propensity to consume of the urban 
wage earners is higher than that of the farm workers. Fourth, 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 people do not earn but they do 
consume commodities. Consequently, the increase in their numbers has tended to 
shift their consumption function upward.
―Factors, Like these, according to the absolute income theory have caused the 
consumption function to shift upward by roughly the amount necessary to 
produce a proportional relationship between consumption and income over the 
long run and thus to prevent the appearance of what would otherwise be the non�proportional relationship that would be expected on the basis of the income 
factors alone.

The absolute income hypothesis is explained in figure above, where CL is the 
long run consumption which shows the proportional relationship between 
consumption and income as we move along the long run curve. For instance, the 
APC and MPC are equal at point A and B on the curves C1 and C2 are short run 
consumption functions.

Self Assessment Exercise
i. Give critical account of absolute income hypothesis.


The relative income hypothesis of James Duesenberry is based on the rejection 
of the two fundamental assumption of the consumption theory of Keynes. 
Duesenbery state that (1) every individual‘s 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.
In formulating his theory of the consumption function, duesenberry write: ―A 
real understanding of the problem of consumer behaviour must begin with a full 
recognition of the social character of consumption pattern. By the ―social 
character of consumption pattern‖ he means the tendency in human being not 
only ―to keep with the Joneses‖ but also to surpass the Joneses. In other words, 
the tendency is to strive constantly towards a higher consumption level and to 
emulate the consumption patterns of one‘s rich neighbors and associates. Thus 
consumers‘ prefaces are interdependent. It is, however, differences in relative 
income that determine the consumption expenditure in a community. A rich 
person will have a lower APC because he will need a smaller portion of his 
income to maintain his consumption pattern. On the other hand, a relatively poor 
man will have an higher APC because he tries to keep up with the consumption 
standard of his neighbour or associates. This provides the explanation for the 
constancy of the long-run APC because lower and higher APCs would balance 
out in the aggregate. Thus even if the absolute size of income in a country 
increases, the APC for the economy as a whole at the higher absolute level of 
income would be constant.
The second part of the Duesenberry theory is the ―past peak of income‖ 
hypothesis which explains the short run fluctuation in the consumption function 
and refutes the Keynesian assumption that consumption relations are reversible.
The hypothesis states that during a period of prosperity; consumption will 
increase and gradually adjust itself to a higher level than for a family to reduces 
its expenditure from a higher level than for a family to refrain from making high 
expenditure in the first place.‖ Thus as income falls, consumption declines but 
proportionately less than the decrease in income because the consumer dissaves 
to sustain consumption. On the other hand, when income increases during the 
recovery period, consumption rises gradually with a rapid increase in saving.
Duesenberry combines his two related hypothesis in the following form:
Where C and Y are consumption and income respectively, t refers to the current 
period and the subscript (0) refers to the previous peak, a is a constant relating to 
the positive autonomous consumption and n is the consumption function.

Self Assessment Exercise
i. Give critical account of relative income hypothesis.


Another solution to the apparent contradiction between the proportional long-run 
and non- proportional short-run consumption function is Friedman‘s permanent 
income hypothesis. Friedman reject the use of ―current income‖ as the 
determinant of consumption expenditure and instead divides both consumption 
and income into ―permanent‖ and ―transitory‖ component so that Y = Yp+ Yt
C = Cp+ Ct and were P refers to permanent and t refers to transitory income Y
and consumption C.
Permanent income is defined as ―the amount a consumer unit could consume (or 
believe that it could) while maintaining its wealth intact.‖ It is the main income 
of a family unit which in turn depends on its time-horizon and farsightedness. ―it 
includes non-human wealth that it owns, the personal attributes of earners in the 
unit . . . the attributes of the economic activity of the earners, such as the 
occupation followed, the location of economic activity ,and so on.‘‘
Y is the consumer‘s measured income or current income; it can be larger or 
smaller than his permanent income in any period. Such differences between 
measured and permanent income are due to the transitory component income 
(Yt).Transitory income may rise or fall with windfall gains or losses and cyclical 
variation. If the transitory income is positive due to a windfall gain, the measured 
income will rise above the permanent income. If the transitory income is 
negative due to theft, the measured income falls below the permanent income. 
The transitory income can also be zero in which case measured income equals 
permanent income.
Permanent consumption is defined as the value of the services that it is planned 
to consume during the period in question. Measured consumption is also divided 
into permanent consumption (Cp) and transitory consumption (Ct).Measured consumption (or current consumption) may deviate from or equal permanent 
consumption depending on whether the transitory consumption is positive, 
negative or zero, Permanent consumption is a multiple (k) of permanent income, 
Cp = kYp‘ And
K= f(r, w, u)
Therefore, Cp =K (r, w, u) Yp
Where k is a function of the rate of interest (r), the ratio of property and non�property income to total wealth or national income (w), and the consumer‘s 
propensity to consume (u).The equation tells that over the long period 
consumption increases in proportion to the change in Yp. This is attributable to a 
constant k (=Cp|Yp) which is independent of the size of income .Thus k is the 
permanent average propensity to consume.

Self Assessment Exercise
i. Explain in detail your understanding of permanent income hypothesis.


Ando and Modigliani formulated a consumption function which is known as the 
Cycle Hypothesis. According to this theory, consumption is a function of 
lifetime expected income of the consumer available to him, the rate of return on 
capital, the spending plan, and the age at which the plan is made. The present 
value of his income (or resources) includes income from assets or property and 
from current and expected labour income.
Before discussing the life cycle hypothesis, its assumption should be noted (1) 
there is no change in price level during the life of the consumer. (2) The rate of 
interest remains stable. (3) The consumer does not inherit any assets and his 
assets are the result of his own savings.
The aim of the consumer is to maximize his utility over his life time which will, 
in turn, depend on the total resources available to him during his life time. Given 
the life span of an individual, his consumption is proportional to these resources. 
but the proportion of resources that the consumer plans to will depend on 
whether the spending plan is formulated during the early or latter years of his 
life. As a rule an individual‘s average income is relatively low at the beginning 
of his life. This is because the early years of his life he has few assets and during 
his late years his labour income is low. It is, however, the middle of his life that 
his life that his income both from asset and labour is high. As a result, the 
consumption level of the individual throughout his life is somewhat constant or 
slightly increasing.

Self Assessment Exercise
i. Give the analysis of life cycle income hypothesis


We explained various theories of consumption function starting from absolute 
income hypothesis through relative income hypothesis and permanent to life 
cycle income hypothesis. The conclusion here is that individual theorists 
concluded that different factor has been the major influence of consumption at 
any particular period.


This unit looked at concept of consumption and its determining factors, in 
relation to various theories of consumption expenditure function. And 
summarises that in accordance to different theorists, that different factors all 
together influence consumption at any point in time.


i. Define consumption theory
ii. List and explain components of consumption function according to 
absolute income hypothesis.
iii. Compare and contrast permanent and life cycle income hypothesis.
iv. Enumerate and explain relationship between absolute income 
hypothesis and relative income hypothesis.


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