Thursday, August 27, 2009

Concept of Propensity

Consumption function or propensity to consume establishes a relationship between consumption and income. As consumption means the amount spent on consumption at a given level of income, but consumption function or propensity to consume means the whole of the scheduled showing consumption expenditure at various levels of income. It tells us in short, how consumption function increases as income increases. The consumption function or propensity to consume therefore indicates a functional relationship between two aggregates viz total consumption expenditure and the gross national income. It is a schedule that expresses relationship between consumption and disposable income. In the words of J. M Keynes “Men on average as a rule have a behaviour that when their incomes increase, they increase their consumption, but not as much as their incomes increase”.

In this regard Keynes propounded a Law based on the analysis of consumption function. This Law consists of three related propositions.

(i) When aggregate income increases, consumption expenditure will also increase but by some what smaller amount. The reason is that as income increases more and more of our wants get satisfied, hence not as much is again spent on consumption as the increase in income. Consumption expenditure will not doubt increase but not to the same extent as increase in income.

(ii) The second proposition is that when income increases, the increment of income will be divided in same proportion between saving and consumption. This really follows from the first proportion. Since consumption spending does not increase at the same rate as the increase in income, apart of the increase is saved and only a part is consumed. That is why consumption and savings go side by side. What is not consumed is saved. Saving is thus the complement of consumption.

(iii) The third proposition included in Keynes Law is that as income increases both consumption spending and saving will go up. An increment of income is unlikely to lead either to less spending or less savings than before. It will seldom happen that a person may decrease his consumption or his savings when he has got more income. He will spend a little more than before and also save more than before.

SIGNIFICANCE OF CONSUMPTION FUNCTION:

Consumption function is not to be considered merely a subject of study and analysis. It has a great theoretical and practical importance. All countries want to remove unemployment from their midst raise their national income and enjoy prosperity for this purpose a policy of planned economic development is essential.

Consumption function underlines the crucial importance of investment. Because propensity to consume is stable, employment can be created only by increasing investment consumption function tells us that that people spend proportionately less than the increase in their income. Therefore, it becomes necessary to fill the gap between income and consumption by increasing investment, other wise it will not by profitable to increase output and employment we also know that consumption is more or less stable. Hence it is instability of investment which is responsible for fluctuations in income and employment in a country. It is therefore clear that investment plays a vital role in increasing income and employment in a country. If propensity of consumption could also increase, income and employment could be increased even without increasing investment. But since consumption function is stable, investment is the crucial and initiating determinant of the levels of income and employment.

Consumption function explains the turning points of business cycle. The trade cycle takes the downward course because the marginal propensity to consume is less than unity i.e. the people does not spend proportionately more as their income increases. Similarly the consumption function explains the upturn of the business cycle. This is due to the fact that since consumption is stable, people are unable to cut down their consumption expenditure to the full extent of a decrease in their income. It shows the danger of permanent over-saving gap and thus explains the decline in the marginal efficiency of capital.

Thus consumption function occupies a very important place in the theory of employment.

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