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Psychological law of consumption: (assumptions and and implication).

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Psychological Law of Consumption: (Assumptions and and Implication)!

The Keynesian concept of consumption function stems from the fundamental psychological law of consumption which states that there is a common tendency for people to spend more on consumption when income increases, but not to the same extent as the rise in income because a part of the income is also saved. The community, as a rule, consumes as well as saves a larger amount with a rise in income.

Thus, Keynes’ psychological law of consumption is based on the following propositions:

i. When the total income of a community increases, the consumption expenditure of the community will also increase, but less proportionately.

ii. It follows from this that an increase in income is always bifurcated into spending and saving.

iii. An increase in income will, thus, lead to an increase in both consumption and savings. This means that with an increase in income in the community, we cannot normally expect a reduction in total consumption or a reduction in total savings. A rising income will often be accompanied by increased savings and a falling income by decreased savings. The rate of increase or decrease in savings will be greater in the initial stages of increase or decrease of income than in the later stages.

The gist of Keynes’ law is that consumption mainly depends on income and that income recipients always do not tend to spend all of the increased income on consumption. This is the fundamental maxim upon which Keynes’ concept of consumption function is based.

Keynes’ law is limited by the following assumptions:

1. Constancy of Psychological and Institutional Factors:

Propensity to consume will remain stable owing to the constancy of the existing psychological and institutional complexities influencing consumption expenditure.

2. Normal Economic Conditions:

General economic conditions are normal and there are no abnormal and extraordinary circumstances such as war, revolution, inflation, etc.

3. Laissez-faire Policy:

It is assumed that there exists a free capitalist economy, in which there is no government restriction on consumption when income increases.

Implications of the Psychological Law of Consumption :

A more detailed analysis of Keynes’ law shows that it has the following important implications:

1. Highlighting the crucial importance of investment in an economy:

A vital point in the law is the tendency of people not to spend on consumption the full amount of an increase in their income. There is thus a “gap” between aggregate income and aggregate consumption.

Assuming the consumption function to be stable during a short-run period, the “gap” will widen with an increase in income. This gives rise to the problem of investment. Investment should be increased to fill the gap between income and consumption. Keynes, therefore, stresses that investment is the crucial and initiating determinant of levels of income and employment.

2. Refuting Say’s Law:

It refutes Say’s Law of market by indicating the demand deficiency and possibility of over-production.

3. Explanation to the Business Cycle:

An explanation of the turning points of a business cycle is also provided by this law. The upper turning point from a boom is caused by a collapse of the marginal efficiency of capital owing to the fact that consumption expenditure does not keep pace with increase in income during the prosperity phase.

Similarly, the law explains the revival of the marginal efficiency of capital and the turning point of recovery from a depression, on the basis of the fact that when income is reduced consumption expenditure does not decrease in the same proportion.

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Psychological law of Consumption

Psychological law of consumption assignment help.

Psychological Law of Consumption is based upon his observations can conclusion derived from the study of consumption function. Consumption function is the functional relationship between the income and consumption of the people. This can be stated as follow as follows:

• When the aggregate income of a person increase, his expenditure on consumption would also increase, but the increase in the income. This is because as the income increase, more and more of wants are satisfied. Hence, comparatively less and less is being spent when income increase. Of course, consumption expenditure does increase when the income rises, though only by a small amount.
• The second proposition relating the law of consumption is that with an increase in income, the additional income will be divided in some proportion between saving and consumption. This obviously follows from the first proposition. Since the expenditure on consumption does not increase at the same rate as an increase at the same rate as an increase in income, a part of income is bound to be saved. Thus, consumption and savings go hand in hand. what is not consumed , is saved.
• The third proposition regarding the law of consumption is that with the increase in income, both saving and spending would go up. An increase in income is unlikely to reduce the level of consumption and saving from their earlier position. It is not generally seen that a person decrease his consumption when the income increases. In fact, when the income rises, he would spend a little more than before And at the same time is savings would also be a little higher than the previous level.

These three observations regarding the behavior of consumption with an increase in income have come to be popularly known as Keynes’ Psychological Law of Consumption. The law, as enunciated by these observations would hold good on by when the following three assumptions are satisfied.

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Keynes Psychological Law of Consumption

Throughout the history of economics, there have been numerous economists that introduced new theories and laws. While some of them were accepted and contributed to the modern economic system, others simply perished with time. Keyne’s psychological law of consumption is one that is still being used today.

What is Keynes’s Psychological Law of Consumption?

This law is known by two other names, Consumption Function and Fundamental Psychological Law. This is more or less an economic formula that portrays the association between income and consumption formulated by a British economist, John Maynard Keynes, in 1936. Although this law has the word ‘psychological’ in its name, the psychological aspect is the general observation of consumer behavior. According to this law, a portion of the raised income that is spent on consumption known as the marginal propensity to consume (MPC), and marginal propensity to save (MPS), which is how savings are influenced by increased income, are greater than zero but less than one.

Assumptions of Psychological Law of Consumption

1. Normal Conditions

The first condition of this law is that it only applies during stable conditions, i.e., this law does not uphold during the time of war, recession, expansion, political issues, strikes, natural disasters, and more.

2. Constant Psychological and Institutional Complex

Once again, this law only applies when the psychological and institutional complex remains the same. Here, the psychological and institutional complex refers to aspects like population, preferences, habits, fashion, and more.

3. Capitalist Economy

This is self-explanatory, as, within a capitalist economy, people are free to choose between products and can purchase whatever goods and services are required. Whereas, in a communist economy, the state is constantly interfering with the production and supply of products and services. Also, the competition is eliminated, resulting in people only buying what is available.

Propositions of Psychological Law of Consumption

1. Increase in Consumption

When the aggregate income increases, it results in an increase in aggregate consumption, but only by a small amount, meaning that when the gross income is increased, so do the consumption and saving; however, the increase in the level of consumption is always less than the increase in the level of income. The reason for the increase in savings is that the necessities are already fulfilled.

2. Bifurcate Consumption and Savings

The total income after the raise is divided between consumption and saving. Although the proportions of this division vary, the consumption is usually higher than saving. It can be represented as:

∆Y= ∆C + ∆S Where, ∆  signifies change ∆Y represents the change in income ∆C means the change in consumption ∆S shows the change in saving

3. Non-declining Factors

Both consumption and saving will increase with an increase in income; however, these two can never decrease with an increase in income.

Implications of Psychological Law of Consumption

1. Importance of Investment

As mentioned previously, this law states that consumption is always less than the increase in income, therefore, creating a gap between the aggregate income and aggregate consumption. Moreover, as the income continues to rise over time, so does this gap. John Maynard Keynes strongly suggests that investment is crucial to bridge the gap between consumption and income.

2. Against Say’s Law of Markets

The psychological law of consumption goes against Say’s law of the markets, as it indicates deficiencies of demand and the possibility of excessive production. According to Say’s law of markets, the ability of the buyer to purchase a good or service depends on their ability to produce. This law was developed by Jean-Baptiste Say, a French economist, in 1803, and he stated that economic growth solely relies on production, i.e., higher production means higher economic growth. Unsurprisingly, Say’s law is mostly abandoned in the modern world.

3. Business Cycle

A business cycle refers to the cycle of expansion and contraction experienced by a business. The decline in the marginal efficiency of capital is observed because the entire output of a business cannot be sold to the customers. Usually, the decline of the marginal efficiency of capital occurs at the peak of expansion or during a recession. Here, the marginal efficiency of capital is the expected amount of profitability.

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Explain Keynes Psychological Law of Consumption | Psychological law of Consumption

Keynes psychological law of consumption states that when income increases, consumption also increases but increasing consumption is less than increasing income and the part of income which is not consume is saved.

Hi friends welcome to my website khanstudy.in, in today’s article we are going to know about Keynes Psychological Law of Consumption (Psychological law of Consumption) .  So let’s discuss in details.

Table of Contents

Keynes Psychological Law of Consumption

The main basis of consumption function is the psychological law propounded by Keynes. The law implies that there is a tendency on the part of the people to spend on consumption less than the full increment of income.

Assumption of Keynes Psychological Law of Consumption

The Keynes law is based on the following assumption –

(i) This law is based on the assumption that the psychological and institutional complex influencing consumption expenditure remain constant.

(ii) The law is applicable under normal conditions.

(iii) The law operates in a rich capitalized economy, where there is no government intervention.

Propositions of Keynes Psychological Law of Consumption

Let us now the main propositions of the psychological law of consumption, these are explained below –

(a) When income increases, consumption expenditure also increases but by a smaller amount. Symbolically,

ΔC/ΔY < 1 or ΔC < ΔY

(b) As increase in income is divided into some ratio between consumption and saving. It implies that a part of increasing income which is not spent in consumption is saved. Thus, symbolically,

ΔY = ΔC + ΔS

(c) With the increase in income, both consumption spending and saving will either lead to less spending or less saving before. Thus symbolically,

ΔY > 0 then ΔC > 0 and ΔS > 0.

The Keynes psychological law of consumption and the three above mentioned propositions of the law can be understand with the help of following table and diagram –

Table and Diagram of Keynes Psychological Law of Consumption

In the above table, when income of the community has increased by 300 crore consumption increases by 290 crore and verifying the first propositions which says that when income increases consumption also increases but less than income.

The increases in income by Rs.300 crore is divided in a constant proportion through between consumption and saving, consumption increases by Rs.10 crore with each income increases by Rs.300 crore.

Diagrammatically, it also be explained in the following figure –

It starts not from the origin ‘O’ but from point ‘A’ implying that even when income is zero, consumption is not zero because some basic needs of the people must be satisfied even if the income is zero.

Till point ‘E 0 ‘ as shown in the figure consumption is more than income. The excess consumption expenditure over and above the income level is met up by utilizing previous saving which is called dissaving.

As for example at OY 1 (= E 1 Y 1 ) level of consumption is more than income. The excess of consumption over income is met up by dissaving of the figure S 1 Y 1 (= C 1 E 1 ). E 0 is the break event point of the economy, because at this point consumption equals the level of income.

After this as income increase, consumption will also increase but not at the same part of income which is not consume is saved. In diagram at OY 2 (= E 2 Y 2 ) level of income. Consumption spending C 2 Y 2 (Y 2 S 2 ) reflects the amount of saving.

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Keynes’ Psychological Law of Consumption Function || Consumption Function and Saving Function || Bcis Notes

September 8, 2019 Killer Whale Introductory Macroeconomics 0

Keynes’ Psychological Law of Consumption Function

Keynes’ Psychological Law of Consumption Function was proposed by J.M Keynes which forms the basis of the consumption function. It explains the nature of the propensity to consume schedule. The law states that people have a tendency of spending less proportion of increased income on consumption because a part of income is saved. The law is based on the following propositions: Proposition I: When aggregate income increases, consumption expenditure also increases but by a smaller amount. It is because as income increases, people are able to satisfy their wants side by side so that the need to spend more on consumer goods diminishes. Y ↑ → C↑  But C<Y Proposition II: the increased income will be divided in some ratio between consumption and saving. This proposition is followed from the first proposition because when the whole of increased income is not spent on consumption, the remaining is saved. Hence, consumption and saving together. Y →  C+S Proposition III: Increase in income always leads to an increase in both consumption and saving. Y ↑→ C ↑ S↑

Proposition I: Income increases at each stage by Rs 100 crores, consumption increases at each stage by Rs 80 crores. Thus, when aggregate income increases, aggregate consumption also increases, but by a somewhat smaller amount. Proposition II: At any two consecutive periods, ∆Y = 100, ∆C= 80, ∆S = 20. Hence, the increased income of Rs 100 crores in each stage is divided into some ratio between consumption and saving. Hence, increased income is divided into consumption and saving. Proposition III: As income increases from Rs. 200 to 300, 400 and 500 crores, consumption increases from Rs 200 to 280, 360 and 440 crores, along with the increase in saving from Rs 0 to 20, 40 and 60 crores, respectively. Hence both consumption and saving increase with an increase in income.

In the figure, when income increases from OY0¬ to OY1, Consumption also increases from EY0 to C1Y1, but the increase in consumption is less than the increase in income, i.e., C1Y1<CY. Similarly, when income increases from OY1 to OY2, consumption also increases from C1Y1 to C2Y2 and increased saving A2C2>A1C1.

Assumptions of Keynes’ Psychological Law of Consumption Function. 1. This law is related to the short-run because in the short-run distribution of income, price level, population growth, fashion, tastes, behavior, etc., won’t change. Consumption will only depend upon income. 2. There should be a normal situation in the economy for the application of this law. In such a situation, war, revolution, hyperinflation, etc., should not occur. 3. It assumes the existence of a laissez-faire capitalistic economy. It means, this law only operates in a developed capitalistic economy where there is not any kind of government interference. That is, this law won’t be applicable if government intervention occurs.

You may also like this:  Meaning of Consumption Function 

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Propensity to Consume

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• First Online: 17 November 2016
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• John Eatwell 2  

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Keynes defined the propensity to consume as a functional relationship between the level of income and expenditure on consumption, and argued that ‘the amount that the community spends on consumption obviously depends (i) partly on the amount of its income, (ii) partly on the other objective attendant circumstances, and (iii) partly on the subjective needs and the psychological propensities and habits of the individuals composing it and the principles on which the income is divided between them’ (Keynes, 1936, pp. 90–91).

This chapter was originally published in  The New Palgrave: A Dictionary of Economics , 1st edition, 1987. Edited by John Eatwell, Murray Milgate and Peter Newman

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Individual Utility Depends Only on Absolute Consumption

Conspicuous consumption, bibliography.

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Eatwell, J. (1987). Propensity to Consume. In: The New Palgrave Dictionary of Economics. Palgrave Macmillan, London. https://doi.org/10.1057/978-1-349-95121-5_1546-1

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10 Major Implications of Consumption Function

The following points highlight the ten major implications of consumption function according to Keynes. The implications are: 1. Vital Importance of Investment 2. General over Production 3. Repudiation of Say’s Law 4. Need for State Intervention 5. Over Saving Gap 6. Decline in MEC 7. Income Propagation 8 . Under Employment Equilibrium 9. Secular Stagnation 10. Turning Points of Trade Cycle.

Implication # 1. Vital Importance of Investment:

One of the most important implications of Keynes’ psychological law of consumption is that it brings about the crucial importance of investment if we want to attain higher level of income and employment. The law says when income increases the gap between income and consumption increases.

The gap is to be filled by bringing more and more investment failing which there will be shortage of effective demand and the economy would slip down. Thus the law highlights the vital importance of investment.

Implication # 2. General over Production:

Since the marginal propensity to consume is less than unity, with every increase in income, consumption would tend to lag behind income which would result in overproduction and unemployment. Thus the law tells us that there can occur a general overproduction and unemployment.

Implication # 3. Repudiation of Say’s Law:

ADVERTISEMENTS:

Keynes with the help of his law of consumption repudiates Say’s law which states supply creates its own demand. Since the marginal propensity to consume is less than unity all that is supplied is not automatically demanded. The supply fails to create its own demand resulting in glut of products in the market.

Implication # 4. Need for State Intervention:

As there is no automatic and self-adjusting mechanism between supply and demand the government should interfere actively to ensure that aggregate effective demand does not fall below aggregate supply.

Implication # 5. Over Saving Gap:

Since the increase in consumption expenditure does not keep pace with the increase in income, there arises the danger of over-saving gap. This danger is more for rich countries than for poor countries.

Implication # 6. Decline in MEC:

As a result of the propensity to consume remaining stable with an increase in income the expected rate of profitability or the marginal efficiency of capital may tend to decline. This can be prevented only by increasing consumption with an increase in income because ultimately the decisions to undertake investments are guided by the volume of consumption.

Implication # 7. Income Propagation:

Keynesian theory explains the slow nature of income propagation. Since the marginal propensity to consume is less than unity, injection of increasing purchasing power into the income stream leads to smaller and smaller successive increments to income.

Implication # 8. Under Employment Equilibrium:

Equilibrium would be attained at full employment only if investment demand happens to be equal to the gap between aggregate income corresponding to full employment and aggregate consumption expenditure out of that income. But Keynes believed that the typical investment demand would not be adequate to fill the gap between the amount of income corresponding to full employment and the consumption demand out of that income. As such the aggregate demand and supply schedules would intersect at a point less than full employment.

Implication # 9. Secular Stagnation:

With the increase in income, since consumption cannot be easily increased and investment demand becomes weaker and weaker the economy may sooner or later reach a stage where it may not be able to provide outlets for its growing savings which is necessary for maintaining full employment. This stage is known as secular stagnation. Such a situation could be avoided if the consumption function were not stable.

Implication # 10. Turning Points of Trade Cycle:

Keynes’ psychological law of consumption is very helpful in explaining the turning points of the trade cycle. When the business cycle reaches the highest point of prosperity, income has increased, but the marginal propensity to consume being less than unity, consumption does not increase correspondingly and the result is the downward start of the cycle.

Similarly when the business cycle reaches the lowest point, income has declined very low but since people do not reduce their consumption to the full extent of decline in income, the upward phase of the cycle starts. Thus consumption function occupies a very important place in the theory of employment.

To Keynes investment refers to real investment which adds to capital equipment. It leads to increase in the level of income and production by increasing the production and purchase of capital goods. Real investment is to be increased to maintain stable national income growth. According to Keynes investment depends on marginal efficiency of capital and rate of interest.

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