The Consumption Function Essay

Custom Student Mr. Teacher ENG 1001-04 16 December 2016

The Consumption Function

To make the income-expenditure model more realistic, we will need to introduce other components of demand, including the government and the foreign sector. But first we need to recognize that consumers planned expenditures will depend on their level of income.

•Consumer Spending and Income The consumption function describes the relationship between desired spending by consumers and the level of income. When consumers have more income, they will want to purchase more goods and services. A simple consumption function can be described by the equation

C = Ca + by

In which total consumption spending, C, has two parts. The first part, Ca, is called autonomous consumption, and it does not directly depend on the level of income. The second part, by, represents the part of consumption that does depend on income. It is the product of the fraction b, called the marginal propensity to consume (MPC), and level of income in the economy, y. The MPC, which has a value of b in our formula, tells us how much consumption spending will increase for every dollar that income increases. If b equals 0.7, then for every $1 that income increases, consumption would increase by 0.7 Χ $1, or $0.70. As firms produce output, they pay households income in the form of wages, interest, profits, and rents. We can therefore use y to represent both output and income.

•Changes in the Consumption Function The consumption function is determined by the level of autonomous consumption and by the MPC. The level of autonomous consumption can change, and so can the MPC. Changes in either shift the consumption function to another position on the graph. A higher level of autonomous consumption but no change in MPC will shift the entire consumption function upward and parallel to its original position. More consumption occurs at every level of income. A number of factors can cause autonomous consumption to change. Here are two:

Increases in consumer wealth will cause an increase in autonomous consumption. Wealth consists of the value of stocks, bonds, and consumer durables (consumer goods that last a long time, such as automobiles and refrigerators). Note that a person’s wealth is not the same as income. Income is the amount of money someone earns during a period, such as in a given year, whereas wealth represents the persons total net worth.

Increases in consumer confidence will increase autonomous consumption ratio. Forecasters pay attention to consumer confidence, a measure based on household surveys of how positive consumers are feeling about the future, because it helps them to predict consumption spending. The Conference Board, a nonprofit organization devoted to disseminating economic analysis, publishes an index of consumer confidence each month that many forecasters rely on. A change in the marginal propensity to consume will cause a change in the slope of the consumption function.

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