CONSUMPTION FUNCTION AND INVESTMENT FUNCTION.

Consumption Function

Psychological law of consumption

Consumption means using goods and services for satisfying current wants. We spend
major portion of our income on consumption. Consumption expenditure means house
hold spending which satisfies our immediate wants. Under this section we will study the
relationship between consumption and income. The pattern of consumption expenditure
for all families is more or less the same. We can see that families have tendencies to
increase consumption with increase in income. This relationship between consumption
and income is called Consumption Function. Consumption is a function of income.

MPC – Marginal Propensity to Consume, the ratio of change in total consumption to

change in total income.
It says that when income increase, the consumption will increase but less than the
increase in income. This is called the Psychological law of consumption because people
do not consume all the increase in the income in the current period because they have to
save for their future. This consumption behavior of a family helps us to understand
community behavior. J. M. Keynes introduced the concept of consumption function at
macro level as aggregate consumption function.

Relationship between MPC & APC.

Aggregate consumption function is relationship between planned or desired consumption

expenditure and level of nation income (NI).

Determinant of consumption:-

There are two groups of factors that effect consumption function.

Subjective or internal factors.

These are related to psychological characteristics of human wants. These factor changes
more in long run rather than short run. These factors are;
a. Precaution motive – Every individual has a strong feeling to prepare for
unseen emergencies like sickness, accident, unemployment etc. So they
build up reserves for such emergencies.
b. Foresight motive – Every man has future needs. They need to save for old
age, educational needs of children, Marriages of daughters etc.
c. Motive for independence – Most of us have a strong desire to be
independent financially. So we tend to save by sacrificing present
consumption.
d. Standard of living – We always want to improve the standard of living for
which we reduce the consumption and save for future.
 e. Status Motive – People feel socially upgraded if they are financially strong
more wealth means higher status or pride.

2. Objective or External factors

a. Distribution of income.-this is an important factor in of propensity to

consume. The more inequality in income distribution the propensity to
consume will be low. Equal distribution of income increases the
propensity to consume. Poor people have higher MPC as their basic or
primary needs are not satisfied. So increase in income tends to increase in
MPC, where as rich people have lower MPC.
b. Expectations – Every consumer has certain calculations about their future
changes. This may be regarding the price, income or employment. When
they expect price increase in the future they tend to consume now or if
they expect unemployment in future they tend to consume less and save
more.
c. Windfall gains or losses – When consumer gets huge profit they tend to
consume more as income increases where as loss will make them consume
less due to decrease in income.
d. Fiscal policies - Fiscal policy is related to tax structure and government
expenditure. When the taxes are decreased the disposable income with
people will increase and so the consumption and vice versa.
e. Stock of wealth – If any individual has enough stock of wealth in the form
of bonds, fixed deposits etc., he tends to consume more from his current
income. But if the stock of wealth is low the individual will spend less and
tend to save more

Practical significance of Consumption Function

1. Useful in firms and business

The concept of APC and MPC are useful in estimating demand for products in future.
The estimation of future demand is important for decisions like expansion,
diversification and modernization. If the MPC is high, business men know that the
demand for the product is likely to increase. But if the MPC is low, the demand will
decrease.
2. Helps in explaining Business Cycle.
Business Cycles are the upswings and downswings in economic activity. The phases
from depression to recovery than from expansion to recession are set by consumption
function. The decline in MPC undermines the prosperity phase and gives way to
recession. But MPC will not fall in the same ratio as decrease in income and
Depression is arrested through MPC.
3. It is the base for Multiplier.
MPC is base for Multiplier. The process of Multiplier explains the income increase and
relationship with MPC. Multiplier is explained in detail in the coming section of
investment function.
Multiplier:

Multiplier concept is associated with R. F. Kahn. He said that whenever the government
takes up some public works this leads to employment opportunities in the economy
which is called a employment Multiplier. Later on, this concept was developed by
Keyens. He said this concept is based on a simple logic; one man’s expenditure is another
man’s source of income. So a small autonomous investment leads to multiple increase in
income.
Definition of Multiplier:- The ratio of change in National Income resulting from change
in autonomous investment .We assume that the investment here is autonomous
investment that is government investment. Multiplier says an initial autonomous
investment leads to multiple increase in income.

MPC, MPS and Multiplier.

Consumption Function is the basis for Multiplier. Whenever the income increase the
consumption also increase. The increase in the demand needs an increase in the supply
and so that employment also increases therefore income increases.

Let us see the value of Multiplier.

If the MPC is 100% that is when the income increase, it leads to increase in consumption
by same amount. The Multiplier will be infinite. So when MPC = 1 Multiplier will be
infinite. This is because when consumption increase there is a increase in demand and so
increase in employment to increase the supply.
If the MPC is 0 that is an increase income has no increase in conception that means
people save the entire increase in income. The Multiplier will be 1.
That is when MPC = 0, K = 1
But in real life, MPC is always more than 0 and less than 1. So the Multiplier value will
be greater than 1 but less than infinity.
So the value of Multiplier is used by the following formula
To summarize the relation between MPC and Multiplier you have to remember three
points
>Higher MPC, K is stronger
>Lower MPC, K is weaker
>MPC = 0, K=1
> MPC = 1, K is infinite

Assumptions:

1. Autonomous investment: - The investment is assumed to be autonomous

investment that is for public work taken up by the government.
2. Availability of idle capacity : -The Multiplier will work only if there is excess
capacity in the economy so that due to investment when the demand increase
 there is capacity to increase the supply or else only the price will rise and lead
to inflation.
3. No leakages: - If there is foreign trade then increase in income is used for
buying imported goods. Multiplier effect will increase the demand for foreign
goods and go outside the country .So the full value of Multiplier cannot be
realized in an open economy.
4. No time lag: - It is assumed that there will not be enough gaps between
income and consumption expenditure to have Multiplier effect.
5. There is not much change in stabilization policies. It is assumed that there no
change in monitory and fiscal policy because when these policies changes
there is change in the MPC of consumers which leads to change in value of
Multiplier.

Significance of Multiplier: -
This concept is not just theoretically important but also has practical significance.

1. Public investment – Multiplier show a strong case of government investment. In

case of depression the government investment is really important and gives
positive effect through Multiplier. Because of small investment there is multiple
increases in income in an economy.
2. Useful in planning employment policies: - This is useful in framing a national
employment policy. It helps estimating how much government expenditure or
autonomous investment is required to reach full employment because whenever
there is small investment made the income and demand increase and so the
employment.
3. Forecasting demand in response to government expenditure:- Multiplier is useful
to government to bring about the change in aggregate demand and aggregate
consumption in response to its autonomous investment. If MPC is 0.80 and
government undertakes autonomous investment of Rs.100 Cr the aggregate
demand will be higher by Rs.500 Cr. National Income increase and aggregate
demand consumption increases and aggregate consumption increases by 400Crs.
This information is important not only for government but also businessmen.

Investment Function

In the previous section, we discussed Consumption Function. We will now start the
second important concept that is investment. Investment here means capital expenditure
i.e. the expenditure on purchasing physical assets, machinery, equipments etc. Items that
helps to increase productive capacity and output.

Types of Investments.

We will first discuss the types of investment:-

1. Gross and Net investment- Gross is total value of productive assets created during a
 given period say one year. It tells us the resources mobilized by the economy.
Depreciation is part of gross investment.
When we deduct amount of depreciation from gross investment we get net
investment. Net investment creates new productive capacity and employment
opportunity.
2. Private investment and Public investment- Investments made by private companies
and corporate comes under private investment. Investment made by Government
and departmental undertakings is called public investment.

3. Induced and Autonomous investment- Autonomous investment is the investment

which is income in elastic, which means even is the income is zero there is some
amount of investment done by the Government. It does not depend on the change in
the National Income.

In this figure IX-2.1(2) income is shown on x-axis and investment is shown on y-axis.
You can see that even when the income is zero, some amount of investment is made.
Induced investment increases with increase in income and decreases with the decrease in
income.

In this figure IX – 2.1(3) income is shown on x-axis and investment is shown on y-axis.
You can see when income increases the demand and consumption will increase and so the
investment to increase the production and supply and vice versa.
In this figure IX- 2.1(4) income is shown on x-axis and investment is shown on y-axis.
We can see the total investment in the above figure.
Total investment = Autonomous investment + Induced investment

Factors affecting investment.

There are some factors which affect investment.

1. Investment and rate of interest- Rate of interest is considered most important factor in
investment decisions. If the rate of interest increases, the investment will be low and
vice-versa. This was a view given by classical economists. They considered rate of
interest as the only factor determining investment.

2. Marginal Efficiency of Capital (MEC) – Any investment decision depends not only on
rate of interest but also whether or not the expected rate of returns on the investment
is greater than cost of borrowing the funds. In these two factors the MEC is an
important factor because MEC is the expected rate of returns from the investment. If
the returns expected are low then the investment is not profitable because in short run,
rate of interest is stable. In MEC, capital means the real productive assets. MEC
depends on expected rate of returns of a capital asset over its life time which is also
called Prospective Yield and the supply price of capital assets. Any business man will
weigh the prospective yield with the supply price before investing.

1. Prospective yield
2. Supply price.

1. Prospective yield – Induced investment is based on profit motive. Businessmen are

always interested in knowing how much money he can earn by investing in new
productive assets.
The concept of prospective yield is related with the amount of money a businessmen
will get from selling the final product produced by the new amount of capital. In this
again, there are two things. First, the life of the asset as in the above example, we have
given the life of 4 years. Second, the businessmen is interested in knowing the yield or
revenue during the lifetime of the machine, which we have shown Rs 7,000/- every
year. The new machine will not give the same yield every year. That is why it is shown
as Q1,Q2 ,Q3 as prospective yields for the 1st, 2nd and so on. These yields are purely
imaginary and it is the expectation and calculation of the business.

2. Supply Price - The next important valuable is the supply price which is the present
value of capital asset.
To summaries the whole theory. We should remember these points to calculate
profit of interest.

- Supply price of capital

- Technical life of capital assets
 - Estimate the annual prospective yield from capital assets.

MEC, Rate of interest and investment decisions.

The businessmen will decide whether to purchase on the marginal unit of capital by
comparing the prevailing rate of interest with the MEC.

• If MEC >Rate of interest, this additional investment will get profit and investment
is profitable.
• MEC < Rate of interest. The additional investment will get loss and investment is
not profitable.
• MEC = Rate of interest. There is neither gain nor loss from the investment that
means investment expenditure will come to halt.

Factors effecting MEC –

There are some short term and some long term factors.

Short term: - Under these the factors are

1. Expected demand for future:- If the demand is expected to increase ,the MEC will be
higher. If the businessmen feels that the demand will decrease in future, the
prospective yield will be low and so the MEC. So the change in expectation gives
sudden ups and downs in investment decisions.

2. Level of income:- When people experience gains through reduction in tax or gains
in bullish market, the businessmen become more optimistic as they know when
income increase ,the demand will increase and so the MEC is high and it is the other
way when there are huge losses.

3. When consumption changes:- In real life whenever there is a shift in consumption

function the MEC also changes. E.g. If consumption increase in current income then
the businessmen find investment profitable as the demand will increase and so MEC is
high and vice versa.

4. Business expectation:- Investment is something which gives returns only in the future.
Any decision on investment depends on the return which the businessmen expects in
future. If the environment is optimistic that leads to more expectations in future.

Long term factors:-

1. Population growth:- Whenever there is increase in population , there is increase in

demand also. This means the consumer goods demand increases and so the demand for
capital goods also increases. To increase the capital goods there is need to invest more
this increases the expected rate of returns or prospective yield and so the MEC is high.
2. Economic Policies of government:- The long term government also effects the MEC
as in 1991 after the liberalization and globalization, the prospective yields and MEC
increased. Such types of policies make the businessmen more optimistic and
encouraging.

3. Infrastructures facilities: - If the infrastructure facilities are more developing, adequate

and uninterrupted , the calculation of MEC will be higher.

Limitations of MEC:-

1. Investment done by the Government for social purpose has no connection with the
MEC.
2. Practically it is difficult to estimate MEC.
3. Whenever there is contractionary monetary policy the firms may not find funds even if
the projects or investments are profitable
4. Every time the businessmen do not necessarily go for loans. Sufficient funds are
gathered by the businessmen for some projects which are planned for a long time.

MEC and Business Expectation

MEC depends on the businessmen’s expectations which increases due to invention and
goes down due to any threat to the returns on investment. It is also affected by the annual
spirit of the entrepreneur. That is why investments are not always calculations but also
irrational optimism. Business expectations are based on existing events and partly future
facts. The investment decision is not done on actual investment but on the future yields.
Therefore huge expenditure is required but actual returns starts later. These two types of
expectations short term and long terms are based on existing facts whereas long term
expectation is based on the future events.

IX 2.4 Acceleration Principles:

The Multiplier and Acceleration Principle are parallel concepts. This principle is also
called Principle of Acceleration.
• Multiplier shows the effect of consumption on investment.
• Acceleration shows the effect of investment on consumption.

This is so because to produce the final goods, capital goods are also required. Therefore,
if you want to increase the final product, the capital goods which are inputs for these final
goods should also be increased. When consumption increases, the demand for factors of
production will also increases.
Acceleration measures the change in investment good industries as a result of change in
consumption goods industries
.
Eg. If there is an expenditure of Rs. 20 Cr. on consumption goods, it leads to an
investment of Rs.40 Cr in investment goods industries, then acceleration is 2.
Acceleration is usually more than 0.
We will now summarize the difference between Multiplier and acceleration.

• ‘K’ shows effect of change in investment on income and employment where as ‘a’
shows the effect of change in consumption on investment.
• ‘K’ depends on propensity to consume and acceleration depends on durability of
machine.
• ‘K’ depends on psychological factors, whereas acceleration depends on
technological factors.

There are certain practical limitations in this principle.

1. No excess capacity: - If consumer goods sectors have excess capacity induced

investment will not increase. Only after the utilization of idle capacity the
principle will start operating.

2. Surplus capacity:- Acceleration principle works on a very tough condition that

there will be excess capacity in investment industry but not in the industry
producing consumer goods. It is assumed that there is surplus capacity in
investment goods industry, but if there is no excess capacity in machine making
industries there will be postponed delivery and the acceleration will be low.

3. Availability of resources :-when demand increase for capital goods that means
increase in production which again means more employment. So there should be
enough unemployed resources available. But only when the full employment level
is reached there is difficulty in expanding the production.

4. Nature of Demand: - The demand for consumption good should be more or less
permanent for acceleration principle to work because if the demand increase is
temporary, then that will not increase demand for capital goods as these goods are
expensive.