Theories of Consumption Function

Overview of Consumption Theories

Consumer spending accounts for 50% to 70% of total aggregate spending in most world economies. The four fundamental macroeconomic theories of consumption are:

1. Absolute Income Hypothesis (John Maynard Keynes, 1936)
2. Relative Income Hypothesis (James Duesenberry, 1948)
3. Permanent Income Hypothesis (Milton Friedman, 1957)
4. Life Cycle Hypothesis (Franco Modigliani, 1986)

Absolute Income Hypothesis

Formulated by John Maynard Keynes based on the Psychological Law of Consumption, this hypothesis states that current consumption spending is a stable function of current disposable income.

Formula and Key Relationships

$C = C_a + c Y_d$

Where:

• $C$ = consumer spending
• $C_a$ = autonomous consumption
• $c$ = marginal propensity to consume ($\text{MPC}$)
• $Y_d$ = real disposable income

Key constraints: $0 < \text{MPC} < 1$ and $\text{MPC} < \text{APC}$.

Core Propositions

1. Aggregate consumption increases with aggregate income, but by a smaller amount ($\Delta C < \Delta Y$).
2. Any increase in income is split between consumption expenditure and saving.
3. An increase in aggregate income leads to an increase in both consumption and savings.

Multiplier and Macroeconomic Implications

$K = \frac{1}{1 - \text{MPC}}$

• Refutes Say's Law because $\text{MPC} < 1$.
• Explains underemployment equilibrium and the decline in the marginal efficiency of capital (MEC).
• Accounts for over-saving gaps, trade cycle turning points, and secular stagnation.
• Demonstrates the necessity of state intervention to boost aggregate demand during economic downturns.

Permanent Income Hypothesis

Formulated by Milton Friedman in 1957 to reconcile short-run and long-run empirical data. It posits that consumption depends on permanent income rather than current absolute income.

Income and Consumption Components

• Measured Income: $Y = Y_p + Y_t$ (where $Y_p$ is permanent income and $Y_t$ is transitory income)
• Measured Consumption: $C = C_p + C_t$ (where $C_p$ is permanent consumption and $C_t$ is transitory consumption)
• Function: $C_p = k Y_p$ (where $k = \text{APC} = \text{MPC}$)

In the short run, $\text{MPC} < \text{APC}$, reproducing a Keynesian-type function. In the long run, average transitory components equal zero ($Y_t = C_t = 0$), yielding a proportional relationship where $\text{MPC} = \text{APC}$.

Relative Income Hypothesis

Developed by James Duesenberry in 1948, this hypothesis asserts that individual consumption is determined by relative standing in income distribution and past income history.

Key Hypotheses

1. Demonstration Effect: Households emulate the consumption standards of higher-income neighbours ("keeping up with the Joneses").
2. Past Peak Income Hypothesis: Consumption behavior is habitual ($C = f(Y_{ri}, Y_{pi})$).

The Ratchet Effect

When income declines, households resist lowering their accustomed consumption standards, raising the $\text{APC}$. As income recovers, consumption grows slowly until reaching the previous peak. Thus, short-run consumption is non-proportional ($\text{MPC} < \text{APC}$), but long-run consumption is proportional ($\text{MPC} = \text{APC}$).

Life-Cycle Hypothesis

Developed by Franco Modigliani in 1957, this hypothesis states that individuals plan spending to smooth consumption over their entire lifespan.

Behavioral Stages

1. Youth/Student: Borrowing to fund education.
2. Working Life (Ages 20 to 65): Paying off debt and saving for retirement.
3. Retirement: Dis-saving and running down accumulated wealth.

Mathematical Formulation

$C = \frac{W + R Y}{T}$

Or for the aggregate economy: $C = a W + b Y$

Where:

• $C$ = consumption
• $W$ = wealth
• $R$ = remaining working years until retirement
• $Y$ = income
• $T$ = remaining lifespan years

Consumption Function in Underdeveloped Economies

Underdeveloped economies exhibit distinct features that limit classical Keynesian policies:

• Unusually high $\text{APC}$ and $\text{MPC}$ (sometimes $\text{MPC} = 1$) and low $\text{MPS}$ due to unfulfilled basic needs and low income levels.
• High income elasticity of demand for food (near unity).
• Increased income expands demand for self-consumption, causing a drop in marketable surplus and inducing an inflationary spiral if government expenditure expands demand.
• Demonstration effects cause consumption of luxury goods prior to attaining self-sustained growth (Rostow's 'take off').
• A small rich elite often dissipates savings on imported luxury goods rather than productive investment.

Questions & Discussion

1. Critically examine the relative income hypothesis of consumption behaviour.
2. Outline the main features of the permanent income hypothesis and state its implication for fiscal policy.
3. a) Explain briefly any four (4) Keynesian theories of consumption.    b) Which one can you recommend for Nigeria and why?