4.1.1. Consumption

The most important determinant of consumption demand is household income. A consumption function describes the relation between consumption and income. The simplest consumption function assumes that consumption changes at a constant rate as income changes.

Household income plays a crucial role in determining how much a household consumes. The consumption function is a mathematical representation that shows how consumption varies with income. In its simplest form, it indicates that as income increases, consumption increases steadily and at a fixed proportion.

Think of a family that budgets a certain portion of their income for groceries. If they earn $2,000 a month, they might plan to spend$600 on groceries. If their income rises to $2,500, they might increase their grocery budget to$750, reflecting a consistent increase in spending as their income rises.

Of course, even if income is zero, some consumption still takes place. Since this level of consumption is independent of income, it is called autonomous consumption.

Autonomous consumption refers to the necessary consumption that occurs even when a person's income is zero. This can include spending funded by savings or credit because certain basic needs must be met regardless of income levels. It is a crucial concept because it reflects the idea that people will consume essentials even if they have no current income.

Imagine a college student who is unemployed but still needs to buy food, toiletries, and books. They may rely on savings or loans to cover these essential expenses, which exemplifies autonomous consumption.

We can describe this function as: C = C + cY (4.1). Here C is the consumption expenditure by households. This consists of two components autonomous consumption and induced consumption (cY).

The consumption function can be broken down into two parts: autonomous consumption (C) and induced consumption (cY). Induced consumption is the portion that varies with income; it represents how consumption increases as income increases. The term 'c' in the equation is the marginal propensity to consume, which measures how much of an additional dollar of income will be spent on consumption.

Consider a worker who earns an annual salary of $50,000 but also receives a bonus of$10,000. If they decide to spend $8,000 of that bonus, the induced consumption reflects their tendency to spend part of the extra income, while their essential spending remains based on their regular salary.

When income rises by Re 1, induced consumption rises by MPC i.e. c or the marginal propensity to consume. It may be explained as a rate of change of consumption as income changes.

MPC is a key concept in economics that quantifies the change in consumption when there is a change in income. For instance, if someone receives a raise of $100 and decides to spend$80 of it, their MPC would be 0.8. It indicates how much of additional income people are likely to spend rather than save.

Imagine someone who earns $1,000 more in a month. If they choose to spend$700 of that additional income, their marginal propensity to consume is 0.7, which shows they are likely to save the remaining $300.

When income changes, change in consumption (∆C) can never exceed the change in income (∆Y). The maximum value which c can take is 1. On the other hand, consumer may choose not to change consumption even when income has changed. In this case MPC = 0.

The MPC can take values between 0 and 1 inclusive. If it is 1, it means consumers will spend all of their additional income. If it's 0, they choose not to spend any extra income. Generally, consumers will spend a portion of any additional income, which causes MPC to fall between these two extremes.

Consider a scenario where someone gets a promotion and earns an extra $200. They might choose to spend$150 (MPC = 0.75) for buying a new gadget and save $50. Conversely, if someone with two jobs suddenly loses one but decides to keep their spending on luxuries the same, they might have an MPC of 0, as they will not change their consumption habits despite a drop in income.

Imagine a country Imagenia which has a consumption function described by C=100+0.8Y. This indicates that even when Imagenia does not have any income, its citizens still consume Rs. 100 worth of goods.

In this example, the consumption function provides a clear view of consumption patterns in the fictional country of Imagenia. The Rs. 100 of consumption represents the autonomous component, while 0.8 of consumption reflects the additional expenditure as income increases. This model shows how even without income, consumption occurs and how it scales with earned income.

Consider a region hit by a natural disaster. Even if the residents have no current income due to disrupted jobs, they may still rely on emergency funds, community support, or government aid to meet their basic consumption needs, resembling Imagenia's consumption structure.

Savings is that part of income that is not consumed. In other words, S=Y − C. We define the marginal propensity to save (MPS) as the rate of change in savings as income increases.

Savings represent the income not spent on consumption. MPS is similar to MPC but focuses on savings instead of consumption. It shows how much additional income people choose to save. If the MPS is high, it indicates that people prefer to save rather than consume additional income.

If a person earns $3,000 and spends$2,700, their savings (S) would be $300. Now, if they receive an additional$1,000 but only spend $600 of it, the increase in savings would be reflected in the MPS, indicating their tendency to save part of any new income.

Some Definitions: Marginal propensity to consume (MPC): it is the change in consumption per unit change in income. Marginal propensity to save (MPS): it is the change in savings per unit change in income. Average propensity to consume (APC): it is the consumption per unit of income.

This chunk summarizes key economic concepts, defining terms like MPC, MPS, APC, and APS. Each term corresponds to specific behaviors in the economy concerning consumption and savings. Understanding these definitions provides crucial insight into consumer behavior.

When you save your allowance. If you receive $10 a week and decide to save$5, your MPS is high because you're saving half of your allowance. Conversely, if your friend spends $10 weekly, they have an MPC of 1 since they consume all their income.

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