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 .
THE ABSOLUTE INCOME HYPOTHESIS
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
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.
THE PERMANENT 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,
Ya
.
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.
THE LIFE CYCLE 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
CONCLUSION
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.
SUMMARY
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.
MARKED ASSIGNMENT
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.
REFERENCES
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Lagos, Nigeria
Amacher, R and Ulbrich, H, (1986); Principles of Economics, South Western
Publications Co. Cincinnafi, Oliso
Bakare –Aremu T.A, (2013); Fundamental of Economics Principles
(Macroeconomics), Raamson Printing Press, Oke-Afa, Isolo, Lagos, Nigeria
Bakare I.A.O, Daisi, O.R., Jenrola, O.A., & Okunnu, M.A., (1999): Principles
and Practice of Economics (Macro Approach), Raamson Printing Press,
Mushin, Lagos, NigeriaDennis R. A. et-al; International Economics, Mcgraw
Hill Irwin, 8th edition.
Familoni K.A, (1990); Development in Macroeconomics Policy, Concept
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