2. Consumption Function
Theory of consumption function explain relationship
between consumption & income
As per J.M Keynes, consumption expenditure of household
depends mainly on their current income
Other factors influence like interest rate, taxation, amount of
wealth etc.
As per Keynes, when income increases, consumption
increases but in a lesser proportion due to savings factor
Consumption Function is also known as Propensity to
consume
3. APC & MPC
Consumption function can be explained through Average
Propensity to Consume (APC) and Marginal Propensity to
Consume (MPC)
APC – ratio of total consumption expenditure to total
income
APC = C / Y i.e. Consumption / Income
For instance, C = 60,000, Y = 1,00,000
APC = 60000 / 1,00,000 = 0.6 or 60%
Household spends 60% of its income on consumption
4. APC & MPC
MPC – Ratio of change in consumption to change in
income
MPC = C / Y i.e. Change in Consumption / Change
in Income
Instance, change in C = 60,000 to 1,00,000 & Y =
1,00,000 to 2,00,000
MPC = 40,000 / 1,00,000 = 0.4 or 40%
5. APS & MPS
Counterparts of APC & MPC are APS & MPS
APS – Average Propensity to Save
MPS – Marginal Propensity to Save
APS = S / Y (S = Savings, Y = Income)
MPS = S / Y (Change in Savings / Change in Income)
APC +APS = 1 and MPC + MPS = 1
Rich people have more of MPS compared to poor
MPC will be greater than MPS
7. Factors Determining Consumption
Function
2 types of Factors
Objective Factors
Subjective Factors – help in more saving rather than
spending hence consumption is reduced
8. Objective Factors
Size of Income
Price Level
Distribution of Income
Propensity to Save
Future Expectations
Taste & Fashion
Rate of Interest
Sudden Gains or Losses
Ownership of Assets
Corporate Policy (Dividend)
Fiscal Policy
Other Factors (Loans)
9. Subjective Factors
Precaution against illness, accident, unemployment etc.
Future Expectations & Needs
Accumulation of Wealth
Independence
Investment
Speculation
11. Effective Demand
J.M. Keynes emphasises on high level of effective
demand to maintain high level of employment
Effective Dem = Consumption Dem + Investment Dem
Consumption Demand
Demand for final goods & services
Depends upon level of income & propensity to spend
In Short run, it remains stable
12. Effective Demand
Investment Demand
Demand for Capital Goods
Depends upon rate of interest and marginal efficiency of
capital
In short run, rate of interest is stable
Marginal Efficiency of Capital is influential factor in
determining level of investment demand
In short run, consumption demand remains stable hence,
level of employment is influenced by investment demand
13. Marginal Efficiency of Capital
(MEC)
MEC is the expected rate of profitability from a capital asset
Rate of Return expected over & above the cost of an
additional unit of capital asset
Capital Asset is brand new asset & not existing one
Similarly, “return” is expected returns & not existing returns
or actual returns
MEC depend upon prospective yield from capital asset &
supply price of the asset
14. Marginal Efficiency of Capital
(MEC)
Prospective Yield From Capital
Asset
Supply Price of
Capital Asset
Total net return expected
from asset over its lifetime
Net income received by
selling its output
(products manufactured
by machinery)
Net Income = Gross
Income – Cost
Price of asset is considered
before purchasing
Comparison is made
between supply price &
yield from the asset
Investment is made when
yield is more than supply
price
15. MEC
According Keynes, MEC is the rate at which prospective yield
from a new capital asset to be discounted to make it equal to the
supply price of the asset
Supply Price = 10,000 , Prospective Yield = 15,000
MEC = Price gap between them
Formula to equalize prospective yield to supply price
Cr = Q1/(1+r)1 + Q2/(1+r)2 + Q3/(1+r)3 ...... Qn/(1+r)n
Cr = Supply Price of asset, Q1, Q2 = annual returns from capital
asset, r = rate of discount (marginal efficiency of capital)
16. MEC
To find out r, formula can be rearranged as
r = Q1 - 1
Cr
For Instance, Supply Price = 1000 crore, Prospective yield for 1st
year = 1250 crore
r or MEC = 1250 / 1000 -1 = 0.25 or 25%
When MEC is known and Prospective yield is to be calculated
Cr = Q1 1000 = Q1 = 1250
(1+r)1 1+0.25
MEC and Interest Rate is compared, if MEC > Interest rate, then
investment project will be undertaken
17. Investment Demand Curve
MEC curve slopes
downwards from left to
right indicating inverse
relationship between
Investment & MEC
When more investment is
made, prospective yield
will decline supply price
will rise
18. Questions
1. Explain the concept of consumption function
2. Differentiate between APC & MPC, APS & MPS
3. Throw light on the factors influencing consumption
function (Subjective or objective can come as short Note)
4. Sums to Calculate APC, MPC, APS, MPS will come
5. Discuss the concept of Effective Demand
6. Throw light on the concept of MEC with suitable diagram
7. Explain Investment Demand Curve
8. Sums to calculate MEC, Cr, Q will come