Theories of the Consumption Function 1
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The document discusses the theories of consumption function, primarily focusing on Keynesian consumption functions and Kuznets's paradox, which highlights discrepancies between empirical data and Keynes’s assumptions. It explains the absolute income hypothesis, the relative income hypothesis by Duesenberry, and introduces concepts like the 'Duesenberry effect' and 'ratchet effect' regarding consumption patterns relative to income. Ultimately, it examines how consumption behavior is influenced by both individual income changes and societal comparisons.
Theories of the Consumption Function 1
- 1. Theories of the Consumption Function - I 1 Prof. Prabha Panth Osmania University, Hyderabad
- 2. Keynesian Consumption Function 1. Absolute Income Hypothesis: Keynes’ consumption function based on Psychological Law. • Not based on empirical data. • Short run analysis. • Y C , but < Y . • C = a + bY, where a is autonomous C, and b is MPC. • According to Keynes, MPC is constant. • But APC falls as Y increases. 2 13/04/2016 Prabha Panth
- 3. C, S Y C=a+bY MPC = slope of C- function. Is constant Y=C+S 0 APC =slope of radius vector. Falls as Y increases Keynesian Consumption Function 3 13/04/2016 Prabha Panth
- 4. Empirical Consumption Function • Keynes assumed that: – Current absolute C is related to current Y. – C-Y relationship is reversible – consumers will increase C when Y increases, and decrease C when Y decreases. – Consumer’s C-patterns are determined autonomously. That is, consumers’ C is independent of other’s C. – APC as Y, and – MPC remains constant as Y. 4 13/04/2016 Prabha Panth
- 5. Kuznet’s Paradox • Empirical data does not entirely support Keynes’ C-function. • Simon Kuznets: showed that behaviour of APC and MPC were not the same for the short run, • and long run consumption functions, • And for cross section and time series data. 5 13/04/2016 Prabha Panth
- 6. • Kuznets’ empirical analysis: – Time series data showed APC is constant for the long run (1889-1938 USA data), around 0.8. – Therefore MPC = APC. – But for Cross section data, or short run, APC falls and APS increases, as Y increases, • This is called Kuznet’s Paradox. • Different economists tried to explain this empirical puzzle, 6 13/04/2016 Prabha Panth
- 7. II. Relative Income Hypothesis • J.S. Duesenberry’s theory of Relative Income. – Consumption is relative to other’s C, as well as to relative Y. – Depends on a person’s position in society, compared to others. – C is irreversible over time, as Y C will not fall at the same rate. – Consumers want to maintain their old standard of living 7 13/04/2016 Prabha Panth
- 8. C = a + bYt + bYt-1 According to Duesenberry (cross section data): • If one person’s Y, and Ys of all others also increase at the same rate, then C – function shifts upwards. • Relative position will not change and there will be no change in consumers’ C/Y. • This means APC and APS remain constant. • Supports Kuznet’s findings of empirical analysis. 8 13/04/2016 Prabha Panth
- 9. C, S Y 0 Y=C+S C1 A B A1 B1 C2 DUESENBERRY’S RELATIVE INCOME HYPOTHESIS When Y and C of both A and B increases at the same rate, then C-function shifts upwards, and APC of both remain constant. 9 13/04/2016 Prabha Panth
- 10. • But if a consumer’s Y increases > others, then his APC more than others. • Relative income hypothesis suggests that HH try to imitate the C of their neighbours. • This is called the “Duesenberry effect” or the “demonstration effect.” • He also suggested that C levels are irreversible downwards. • When Y, C will not fall at the same rate. So APC, when Y • This is called the “Ratchet effect” 10 13/04/2016 Prabha Panth
- 11. C, S 0 Y C Y1 C1 Y0 C0 When Y falls to Y0, C also falls, but APC increases. This is the Ratchet Effect. 11 13/04/2016 Prabha Panth