Factors determining consumption functions | Steps to increase Consumption

The consumption function or the propensity to consume is not static and there are various factors influencing it for a change. Though in the short period, the propensity to consume will not change — as the spending habit of the society docs not change quickly — in a dynamic society, factors will be always operating to make the condition unstable.

We shall discuss some of the important factors that influence the consumption function. Since saving is a complement of consumption, factors influencing consumption will be automatically affecting savings as well.

The causes governing consumption function can be classified into:

  1. Subjective factors and
  2. Objective factors.

The former is called psychological factors by Keynes who lists about eight motives which lead individual to refrain from spending out of their incomes.

Subjective Factors governing consumption function

Consumption function - Subjective Factors
Consumption function – Subjective Factors

1. To build up a reserve against unforeseen contingencies.

2. To provide for an anticipated future relation between the income and the needs of the individual or his family different from that which exist at present, as for example, in relation to old age, family education, or maintenance of dependents.

3. To enjoy interest and appreciation i.e., because a large real consumption at a later date is preferred to a smaller immediate consumption.

4. To enjoy a gradually increasing expenditure since it gratifies a common instinct to look forward to a gradually improving standard of life rather than the contrary, even though the capacity for enjoyment may be diminishing.

5. To enjoy a sense of independence and the power to do things, though without a clear idea or definite intention of specific action.

6. To secure a masse de manoeuvre (Working Mass) to carry out speculative or business projects.

7. To bequeath a fortune.

8. To satisfy pure miserliness, i.e., unreasonable, but insistent inhibitions against acts of expenditure as such.

The above subjective motives are summed up by Keynes as motives of Precaution, Foresight, Calculation, Improvement, Independence, Enterprise, Pride and Avarice. Keynes lists out the motives for consumption also. They are Enjoyment, Shortsightedness, Generosity, Miscalculation, Ostentation and Extravagance.

In addition to savings accumulated by individuals due to various motives enumerated already, savings are accumulated by Central, State and Local governments, institutions and business firms. The motives for these savings are Enterprise, Liquidity, Improvement and Financial Prudence.

According to Keynes, the subjective or psychological factors do not change in the short run and hence consumption function remain stable in the short period.

Objective Factors influencing the consumption function

Consumption function - Objective Factors
Consumption function – Objective Factors

The list of factors under this category affecting consumption is a big one and we shall take up for discussion only very important factors.

1. Money Income

Money income of the individual is the dominant factor in determining his consumption. Income, consumption and savings of an individual are related to each other.

2. Real Income

Keynes points out that the consumption is influenced by real income than by money income. A change in the price level will change the value of money and the purchasing power. Fluctuation in prices will affect real income and also the propensity to consume. Phenomenal rise in the price level will reduce the real income and so there will be a fall in the propensity to consume.

3. Distribution of Income

The most important factor determining consumption function is the manner in which the income or wealth of the community is distributed. Normally the average and marginal propensities to consume will be higher for poor people than the rich; the reason being that the former will be living without many essential and basic needs of life and additional income will be fully made use of in consumption to satisfy basic wants.

On the other hand, the rich may not be having many unsatisfied wants and hence their propensity to save will be higher. Statistical studies have proved that a large portion of investment has come only from the savings of the rich. Consumption will be low when there are gross inequalities of income in the country. Reduction of inequalities will increase the propensity to consume in the economy.

4. Fiscal Policy

The fiscal policy of the government relating to taxation, expenditure and public debt will appreciably affect the propensity to consume. Heavy indirect taxes will leave little money with the people of low-income groups and their consumption will get depressed.

A reduction in taxes will leave more disposable income which can be used for consumption. Highly progressive system of taxation will reduce inequalities which will in turn increase the propensity to consume in the economy.

5. Financial policies of Corporations

If joint-stock companies and corporations adopt a ‘fat dividend’ policy, the disposable income of the shareholders will be high and consequently the propensity to consume will also go up.

6. Expectations of future changes

If the people in the economy expect sudden changes in the future regarding their income, price-level or shortage of commodities or bumper harvest, the consumption function will change.

During war, shortage of commodities will be expected and the consumers will rush to buy far in excess of their needs. If they anticipate bumper crop or massive import which would reduce the prices in the near future, consumption would be postponed to a future date and hence propensity to consume will become low.

7. Windfall gains and huge losses

Sudden windfall income or gains will increase the consumption function, while huge losses will reduce the consumption. In the late twenties, the windfall gains in the stock market of U.S.A., increased the consumption function of the wealthier classes.

8. Liquid Assets

When people have liquid assets, they will be inclined to spend more and the consumption level will be high. During war periods, increased liquidity due to war financing will lead to increased consumption.

9. Rate of interest

Views differ regarding the role of interest in consumption function. The classical view is that if the rate of interest goes up, people will consume less and save more to take advantage of the higher interest rate. When interest rate falls, they will consume more and save less. Consumption varies inversely with the rate of interest.

According to Keynes, the effect of rate of interest on consumption and savings is complex and uncertain.

The short period influence of the interest rate on individual spending out of a given income is secondary and relatively unimportant, except, perhaps where usually large changes are in question.

Only in the long period, changes in the rate of interest influence social habits of the people which in turn affect consumption. Further changes in the rate of interest affect the purchase of durable consumption goods on installment basis.

A rise in the rate of interest makes the installment purchase more expensive and the customers arc discouraged to buy goods. A fall in the rate of interest will increase consumption of goods purchased on installment system.

10. Consumer durable

Consumption expenditure depends on the consumer durable goods available and demanded in the country. If the country had been enjoying prosperity for a long period, the people would be possessing many durable goods with them like motor car, sewing machine, fridge and TV which would serve them for a long time. Hence the people may not be spending on such items, but would save more out of their disposable incomes.

11. Demographic factors

The consumption expenditure differs from family depending on demographic factors, though the income may happen to be the same for all families. ‘Large-sized’ families will spend more than ‘small-sized’ families. Occupation, residence, composition of the family will determine expenditure.

Normally urban-bred families will spend more than rural families. Farmers and small businessmen will spend less than professional people. Families having children attending colleges will be spending more. In short, the propensity to consume depends on tastes, preferences, standard of living and aptitude and attitude of the people.)

12. Duesenberry Hypothesis

Prof. Duessenberry has made two important observations regarding the factors affecting the consumption of an individual:

1. The consumption expenditure of the people not only depends on the current level of income, but also on the standard of living in the past. If income falls, no doubt, the expenditure will also fall, but not to the same extent, as the people will find it difficult to adjust their expenditure to changed conditions.

2. Another important factor is what may be called the Demonstration Effect. An individual’s consumption depends not only on the absolute amount of his income, but also on its size relative to incomes of others.

For example, the low-income group will try to imitate the consumption standard of high-income groups. They will purchase fashion goods and costly commodities used by rich people. But, the moment low-income groups start using these goods consumed by higher-ups, the latter will avoid consumption of these commodities and go in search of still better or valuable commodities. This is what is called the Demonstration Effect which will have mutual reactions resulting in increased consumption function.

Steps to increase consumption function

The fundamental concept of Keynesian employment theory is the ‘Effective Demand‘ which depends on the consumption function of the economy. Though consumption remains fairly stable in the short period, many factors can be used to step the consumption function in the long run to achieve full employment.

Since consumption forms the basis of employment creation, it is the duty of government to aim at the social control of investment and step up investment by adopting suitable policies, The following steps will increase the marginal propensity to consume.

1. Redistribution of Income

We have already studied that distribution of income affects the propensity to consume. The fiscal policy of the government should aim at redistribution of income by means of transfer of resources from the rich to the poor so that the income of the poorer classes would go up. Effective measures in taxation, progressive methods to tax the rich without affecting capital formation would ensure better redistribution of income and wealth in the community. With better redistribution of income the propensity to consume would increase in the economy.

2. Social Security Schemes

A well-planned system of social security measures would increase the consumption function in the economy. Unemployment insurance, old-age pension, health insurance, etc. will help in increasing the productive capacity of the economy and also the consumption function. These schemes will increase the purchasing power of the people and the paradox of thrift common to all capitalist economies would vanish. These measures would help the economy to a great deal during a depressionary period.

3. Wage Policy

Wage policy is a complex problem in the economy and it should aim at increasing the consumption function without any adverse effects. A cut in wages is not a suitable practical policy and a rise in wages will increase consumption function. But a mere rise in wages without increasing the productivity of workers would lead to inflationary conditions and ultimately to unemployment. The wage policy and productive policy should go hand in hand to enable the economy to consume more and grow more.

4. Urbanization

Normally, the propensity to consume will be high in urban and industrialized centres rather than rural areas. A policy of urbanization and starting of urban colonies would enhance the consumption function.

5. Easy credit and sales promotion

Easy credit facilities and installment schemes will enable the consumers to enhance their consumption. Similarly, sales promotion techniques, such as advertisement through press, screen, radio and TV will increase the demand for many durable commodities and the consumption function of the economy would go up.