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Chapter I


Consumption Pattern
Determinants of consumption pattern
Statement of the Problem
Objectives of the Study
General objectives
Specific objectives
Methodology and Data Sources
Sample design
Data Gathering Instruments and Data Collection
Data Management and Analysis
Limitations of the Study
Scheme of the Study
History of the Analysis of Consumption
Consumption : Theoretical Developments
Consumer Behaviour Theory
Micro economic theories
Macro economic theories
New Model

1.1 Introduction
Human life is nourished and sustained by consumption. The abundance of
consumption is the life blood of human development. Just as the sun is the centre
of the solar system, consumer is the prime mover of the economic system.
Consumer and consumer behaviour have existed for ages ever since homohabilis
appeared on earth. Consumer is the king or sovereign in the economic empire.
Consumption habits are determined by a complex set of socio-economic, cultural,
religious, psychological and environmental factors. Typically, a countrys
consumption pattern and its effects reveal a clear picture of its standard of living,
poverty level, human development and the nature of its economic growth.
Economic growth is affected by aggregate demand. If the aggregate
demand is growing fast, the economy is likely to be boosting and


there will be recession in the economy. Consumer expenditure is the total amount
spent by the consumer on produced goods and services and consumer expenditure
is influenced to a great extent by income. A change in disposable income leads to
a movement along the consumption function, but a change in other determinants
of consumer spending will shift the entire consumption function. In this context,
Goyal (1994) viewed that consumption pattern become a habit. As income levels
rise with development and people move into higher income brackets, consumption
levels do not rise continuously (Annapoorani et al, 2003).
Simon Kuznets,( 1995) identified the economic growth of a nation with a
sustained increase in per capita or per worker product, most often accompanied by
an increase in population and sweeping structural changes. According to him
economic growth involves industrialization, urbanisation and change in the
relative economic position of groups within the nation. These changes influence
the level of consumption and consumption pattern in an economy. This means that
there exist a close relationship between consumption and economic growth.
Different theories of consumption indirectly explain the relationship between

changes in consumption and economic growth mainly through changes in per

capita income or national income and changes in the standard of living. Keynes
places consumption function at the very heart of the economic system. In the
growth models also it forms a key parameter and is an important determinant of
the rate of growth.
For a given level of development, consumption pattern varies considerably
over regions and involves complex systems of interaction among various factors
economic, sociological, psychological and ethical. No doubt, consumption affair
is an individual affair, yet the desires and satisfaction of individuals are not
independent of the society to which they belong. The kind of food consumed by
the individuals and the psychological pleasure derived through consumption are
very much influenced by the practices and usages of their ancestors and habits of
their nears and dears (Sethi, 2001).
1.2 Consumption Pattern
Consumption pattern is the proportion of consumption of various goods and
services that an individual is accustomed to. It may be any of the observable
features or characteristics of consumer behaviour. More specifically these
observable features of consumer behaviour include- Patterns of allocation of
consumer income, Patterns of allocation of expenditure for food and non food
items, Patterns of allocation of expenditure for different categories of food and
non-food items, Patterns of allocation of the nature of food and non food items.
Consumption thus describes how consumers act, how they allocate income
among various alternatives, how loyal they are to various brands and how they
react to new products and services. Thus consumption is a symptom of attitudes,
values, beliefs and motives of a consumer or a group of consumers. The behavior
of two consumers may not be similar as two persons are not alike. Even
consumption of a particular commodity by a consumer varies from household to
household. Consumption pattern thus involves a study of these variations in
consumption of different groups of consumers. These variations arise due to
environmental differences among different families.


Determinants of consumption pattern

The determinants of consumption pattern are the factors responsible for

such variations in consumption (Kulkarny, 1991). They are changes in the taste,
habits and preferences of the family, size of the family, income of the household,
the base of the standard of living, geographical background, current and expected
prices in the market, social and religious structure such as caste, tradition etc. age
and education of the head of the household, composition and occupation of family,
life style, availability of consumer goods in installments, influence of
advertisement, interest rates, expected future earnings,. change in wage level,
windfall gain or loss, change in future expectation, change in rate of interest,
holding of liquid assets, distribution of income and wealth between the rich and the
poor, consumer credit, attitude towards savings, fiscal and monetary policy of the
government etc. (Modigliani, 1949). Social attitudes and cultural patterns among
people influence their patterns of consumption. Increased pressure on consumption
is also exercised through the institution of advertisement.
Geographical location of the population plays some role in the consumption
function (Anthony, 1974). Demonstration effect is a more likely characteristic of
cities than of the rural countryside. The urbanization of a country may be
accompanied by pressures to greater consumption and less savings (Edwin, 1993).
Propensity to consume is also influenced by the size of the family. With an
increase in family size, the propensity to consume increases due to increased
demand for food, clothing and other necessities of life (Ashok and Jagadeswara,
1985). Every aspect of household economic behaviour is significantly correlated
with the presence of children in the household. Children affect the allocation of a
given family budget; they affect the household demand patterns in a well-defined
way (Martin and Anna-Maria, 1996).
1.3 Statement of the Problem
The world consumption has expanded at an unprecedented pace over the
20th century with the aggregate consumption expenditure reaching $24 trillion in
1998 which is twice that of 1975 and six times that of 1950. In 1900 real

expenditure was barely $1.5 trillion. The HDR (1998) highlights a new dimension
of current global consumption of goods and services. The report showed that with
the globalization of markets, demand for luxury items and services are increasing
even in traditionally poor countries. Consumption boom could be witnessed
across the world resulting from phenomenal progress of technology and business
management. Due to the expansion of consumer expenditure in an unprecedented
manner more people are better fed and housed than before. But the poorest 20%
of the worlds population is left out of the consumption explosion. The distinction
between necessaries and luxuries is fast disappearing. Household debt particularly
consumer credit is growing while household savings are falling in several
industrial and developing countries.
The consumption pattern in India underwent a sweeping structural change
and now it tends towards assuming a new mobility (Sooryamoorthy , 1997). India
has been projected as the next consumer powerhouse. The economy witnessed
structural and compositional changes in the consumption basket of rural and urban
sectors and income groups over the last three decades.
Kerala has become an enigma and a paradox to many economists and
development experts at national as well as international level (Paul Wallich,
1995). It presents a paradoxical picture of high social development with uneven
economic growth. As regards social development the state has successfully
tackled the first generation problems like illiteracy, high infant mortality rate, low
expectations of life at birth, high birth rate and related indicators of under
development when other states are still grappling with them(Baiju2004). From an
international development perspective, Keralas achievements, despite the states
low per capita income are comparable to or even better than that of countries like
Sri Lanka, China, Costa Rica & Cuba (Sen, et. al, 1995).
Consumption pattern of the people in Kerala across the state exhibits
some interesting features. Amidst several socio-economic, demographic and
geographic characteristics that make the state distinct, consumption is a factor
which stands out. There is a significant increase in the level of consumption of

both food and non food commodities. Keralites seem to be spending a lot of
money on consumer durables

and luxuries (Sooryamoorthy, 1996). Competitive

spending and conspicuous consumption has become the order of the day. Kerala
has been experiencing an unprecedented consumption boom and increasing
standard of living (Ibrahim, 2002). With only 3.4% of the countrys population, it
accounts for 10 % of the total consumption (Madhava Menon, 2000). The value
of consumer articles flowing into the state is estimated to be in the range of 50-60
billion Indian rupees.
For the past two decades, Keralas market has been witnessing the
domination of Multi National Corporations (MNCs) with their branded products
and services. As the world trade is opening up more and more, there are numerous
big groups targeting the Kerala market. For the past few years, MNCs have
invested financial and managerial resources in India to develop the market for
their product, especially in Kerala ( Sreenivasan ,1999). Kerala today ranks at the
top among Indian states in per capita consumption expenditure though its rank in
terms of per capita Net State Domestic Product (NSDP) is relatively lower.
Emigration has become the striking feature of the Kerala economy. The
economic consequences of migration and migrant remittances are found in the
increase in the household income and changes in the income distribution. Money,
mainly from NRI remittances, is steadily flowing into Kerala. Real estate prices
are soaring as NRIs and their families are buying land as an investment or
building ostentatious houses as that is now seen as a glittering status symbol. The
majority of migrants belonged to poor families from rural areas. A sudden spurt in
their income has given rise to a rising per capita household expenditure in the
state (Harilal and Joseph, 2000).Conspicuous consumption has become the
hallmark of an emigrant, especially a Kerala emigrant.
The impact of migrant remittances on the phenomenal increase in income
from salary/ wages has been profound. Foreign remittances to the state gave a
spurt to the consumerist ways of behaviour. Suddenly consumerism found favour
with people especially among the middle and low income groups. The impact is

visible even in villages. Shops have started stocking modern goods hitherto
unknown and unfamiliar to Kerala consumers. Markets and shops got a face-lift.
The changes are overwhelming. In todays consumerism, consumers can hardly
escape from the pressure exerted by innumerable products and services; the
attraction of modern goods is hard to resist. As different from other states in the
country, the people in Kerala recognise consumption as a yardstick to measure
socio economic status and prestige. Consumption of commodities and services
that smack of the luxurious and ostentatious, as opposed to the practical and
essential, has therefore, found acceptance in society. People want to possess
things that are beyond their means. The insensible passion for possession of
consumer goods as a means of improving / maintaining social status has left them
staggering under heavy financial commitment. Unable to pay back the loans taken
from individual and financial institutions many are driven to suicide. According to
the Government of Kerala, 22 families resorted to suicide due to financial reasons




state legislative

assembly in



(Sooryamoorthy , 2007).
During the last few decades dramatic changes have taken place in habits,
items and quantum of food consumption. There has also been a change in our
lifestyle. Our modern society is all geared up to make life easier for us. Labour
saving devices like the mixer, washing machines, vacuum cleaners, refrigerators,
lifts & elevators, automobiles etc. have contributed to decreased activity levels
across all age groups. Increased food intake coupled with a sedentary lifestyle has
resulted in an increasing incidence of overweight and obesity ( Gopalakrishnan,
In this context, the present study is an attempt to go through the changing
consumption pattern in Kerala. An enquiry has been made to find whether there is
any change in the consumption of food and nonfood items among different socio
economic groups .Changes in category, quantity, mode of purchase, place and
frequency of purchase are also analyzed. The changes that have taken place
during the last 10 years are highlighted. The study also analyses the nature of rural

urban divide with regard to the consumption pattern of households and also by
economic categories.

Objectives of the Study

1.4.1 General objective

To study the changing consumption pattern of rural and urban households
in Kerala.
1.4.2. Specific objectives
1. To study the socio-economic and demographic profile of the sample
2. To examine the changes in the consumption pattern in India and Kerala
as per NSSO reports
3. To trace the item- wise changes in the consumption pattern of food and
non-food items in central Kerala and also to find out the specific reasons
behind it.
4. To analyse the changes in the consumption pattern in rural and urban
areas and also by economic categories of households.
5. To examine the association between consumption pattern and socio
economic profile of the households and also the psycho- social factors
affecting consumption.
1.5 Hypotheses

There is no significant difference in the consumption pattern of

households between 2000 and 2010.

There are no wide rural urban differences in the consumption pattern of


There is no significant association in the age, size and level of income of

the household with consumption pattern.

1.6. Methodology and Data Sources

The study is both empirical and descriptive. It covers two districts of
central Kerala- Kottayam and Alappuzha. Change in the consumption pattern
during the period 2000-2010 is analysed. Primary and secondary data are made
use of in the analysis. Primary data has been collected from Kottayam and
Alappuzha districts and secondary data
periodicals, newspapers,

from books, research journals,

various issues of RBI bulletin, Economic Reviews,

Census Reports, Reports of NSSO and Central and state Statistical Organizations,
different websites etc. The prices of the commodities were collected from
Economics and Statistics Department.
1.6.1 Sample design
A multistage sampling procedure has been adopted for selecting sample
households. In the first stage, two Districts from central Kerala Kottayam and
Alappuzha are selected. Factors such as industrialisation, urbanisation, Gulf
migration, mushrooming of shops, increasing sales of vehicles, consumer durables
etc. which influence consumerism is manifested in abundance in Kottayam.
The district of Alappuzha is contiguous to the District of Kottayam.
However, its economy, standard of living and consumption pattern vary
significantly from that of the latter. It is the smallest district in Kerala having the
highest density of population. Kuttanad, the rice bowl of Kerala lies in the district.
It has vast coast line with a large chunk of the population belonging to the
fisherman community. The source of income and its potential vary to a great
extent from that of Kottayam district. Since the majority of the population
depends upon fishing and agriculture for their livelihood, the vagaries of monsoon
have significant impact in determining the income and purchasing power of the


In the second stage, two municipal Corporations and two Grama

Panchayats are selected from the two districts according to simple random
sampling method- Changanacherry municipal corporation and Paippad Grama
Panchayat from Kottayam and Alappuzha Municipal Corporation and Kainakary
Grama Panchayat from Alappuzha.
The sample size (600) is based on the proportion of households in the rural
and urban areas of the two districts. 300 households are selected from each
district. Out of the 368727 rural households and 65719 urban households of
Kottayam district, 240 households are from Paippad Grama Panchayat (rural) and
60 households are from Changanacherry Municipal Corporation (urban).
Similarly out of 345928 rural households and 138032 urban households of
Alappuzha district 216 households are from Kainakary Grama Panchayat (rural)
and 84 households are from Alappuzha Municipal Corporation (urban). These
households are selected from the local bodies list using a systematic random
sampling procedure.
Fig. 1.1
Sample Design
Sample Size




Paippad Grama


No of

No of

No of

Kainakari Grama

No of


1.7 Data Gathering Instruments and Data Collection

An Interview Schedule (appendix 1) has been prepared and pretested for
the collection of data from the sample households. It is divided into ten parts. Part
one consists of the identification details of the households. Part two and three deal
with housing facilities, details of household members, size of the family etc. Part
four is meant for getting information regarding the monthly income of the
households in 2000 and 2010. Part five and six consist of the asset holding and
expenditure pattern of the households. Savings, liabilities and insurance are
included in part seven. Through part eight and nine consumption of food and nonfood items and the changes in their pattern are collected. Households perspectives
on consumption is included in part ten of the schedule.
1.8 Data Management and Analysis
Data collected are validated, entered, cleaned and processed using
Statistical Package of Social Science (SPSS). Several statistical tools have been
used for the analysis of the data. Apart from simple averages and percentages, Chi
square test, Paired t test and Z test have been used. The Chi square test has been
performed to test the interdependence between variables. Paired t test has been
used for testing the differences in mean values between two periods. Factor
analysis has been used to identify the psycho social factors behind the changes in
the consumption pattern.
1.9 Limitations of the Study
The study analyses changing consumption pattern in respect of only two
districts of Kerala. The data collected may have errors due to memory lapse and
the reluctance of the respondents to give the correct information regarding past 10
years and also the hesitation of a few to disclose their income, savings ,asset
holdings etc. It was very difficult to collect the actual data of expenditure for
previous years. Since the number of items comprising food and non-food items
are very large, the number of tables and their sizes were too big to be


accommodated fully in the book. However most of the tables have been included
in the appendix for reference.
1.10 Scheme of Study
The first chapter introduces the research problem, its objectives,
hypotheses, methodology, sample design, tools of analysis, limitations, scheme of
study and theories on consumption. The second chapter contains the review of
various related studies. The third chapter deals with the consumption pattern
scenario in India and Kerala. The fourth chapter is devoted to analysing the socio
economic and demographic profile of the sample households. The fifth chapter
deals with changing trends in consumption pattern of households in Keralaregion- wise, economic category- wise, item- wise and reasons -wise. Association
between variables affecting consumption are also analysed. The last chapter deals
with the findings and conclusions of the study.
1.11 History of the Analysis of Consumption
In the history of demand analysis two related but separable approaches can
be identified. One set of approach is available from the works of Economists
interested in the discovery of general laws governing the operation of markets
particularly agricultural markets and the second set originates from the initial
efforts of statisticians, interested in the psychological laws governing what has
come to be called consumer preference. Brown and Deaton (1972) hold the view
that this dichotomy still continues to characterize the subject. Recently theoretical
economists and mathematicians have developed more sophisticated techniques
which help us in understanding the complex nature of pure mathematics of
preference relations. This interplay between the theory and reality has been
perhaps more fruitful in demand analysis than in any other branch of economics.
In 18


and 19


centuries the empirical approach made little progress in

the measurement of demand curves despite its early and promising beginning .It
was Ernest Engel in 1857 who made an outstanding contribution to demand
theory that turned out to be the most enduring empirical laws governing the


relationship between income and expenditure pattern of the people. In the late
19th century the fusion between the theoretical and empirical approaches in the
writings of Alfred Marshall (1896) acted as a catalyst which inspired agricultural
economists to apply the newly discovered technique of correlations in the analysis
of single markets. Marshalls great contribution was the clarification and
elaboration of the concept of elasticity of demand which offered a precise
framework for numerical measurement of market characteristics.
In the econometric study of demand a substantial progress was achieved by
agricultural economists in the United States beginning with Moore(1929) who
published a number of important studies between 1914 and 1929. By 1939, most
of the strengths and weaknesses of classical demand analysis had been probed
into and most of the techniques still in use had been discovered .This classical
approach can be characterised as the application of variations in least squares
single equation fitting, to both time series and cross section data, of market
models based on the theoretical contributions of Slutsky (1915), Allen and Hicks
(1934) and Hicks (1936)studies by Schultz (1938), Wold and Jureen(1952) and
Stone (1953) can be regarded as a consolidation of the theoretical and empirical
attempts at static demand models in the first half of this century . Since then there
have been a number of important developments in demand analysis. Samuelsons
(1948) introduction of revealed preference theory was a new approach to the
theory of consumer demand. The revealed preference hypothesis is considered as
a major breakthrough in the theory of demand because it has made possible the
establishment of law of demand directly.
1.12 Consumption: Theoretical Developments
Consumption is defined as the total value of expenditures on goods and
services for the current use by the household sector (Henderson and Poole, 1991).
Consumption patterns provide the structure for everyday material life, and this
structure creates economic distance across classes. Consumer goods are divided
according to the consumers needs they satisfy or their utility. A commonly used
classification identifies 10 classes of expenditure: Food, clothing and footwear,









communication, culture and schooling and entertainment (HDR, 1998). People

belonging to different classes of income have different structures of consumption.
Rich people spend more for each class of items in absolute terms but they spend a
low percentage of income for food and other basic needs and poor people spend
higher percentage of income on food and other basic needs. The propensity to
consume will be higher for the poor and the propensity to save will be higher for
the rich (Glenn and Kenneth, 1987). According to Marshall (1949), consumption
expenditure is divided into three categories: Basics, variety and status. These
categories are socially determined and changed over time. Basics are required
for healthful living and for integration into the society and economy; variety is
consumption that reduces drudgery, provides comfort, or makes other tangible
improvement; status is consumption that marks ones social position. Both,
variety and status increase the familys consumption options; as such, both
improve the familys control over its daily life.
1.13 Consumer Behaviour Theory
It is generally accepted that consumer behaviour theory is a post second
world war phenomenon. Since consumption is the predominant component of
aggregate demand in an economy, consumer behaviour occupies a central position
in modern macro economic theory. There are two approaches in the study of
consumption- Micro and Macro. The micro approach consists of two very popular
classes of studies, one dealing with family budget studies and the other with
market demand analysis. Family budget studies deal mainly with the cross-section
relationship between income level and pattern of consumption across categories
of goods and services, holding other variables like price constant. Market demand
analysis on the other hand uses time series data to analyse the relationship
between price and demand. The macro approach however concentrates on the
income consumption relationship in an aggregative sense.
1.13.1 Micro economic theories
The early developments in consumption behaviour were found in micro
economic theories. In micro economic theories the consumption behaviour was


derived on the postulate of utility maximization subject to linear budget constraint

Max .. u ( X1 .. Xn)
Subject to X = pn qn
Where X means total consumption expenditure
Pn denote prices
qn denotes quantities consumed and demanded.
The Marshallian demand function was described as
q1 = f1 ( X1 P)
where , q1 is the quantity of ith good.
Broadly speaking, there are two approaches in the analysis of household
consumption behaviour. One based on aggregate time series data on quantities,
prices of commodities consumed and on aggregate income. (2) the other based on
incomes and expenditure of a cross section of individual households in a given
period of time. Under the former approach the problem of the lack of availability
of comparable data over time may arise (Mahajan B.M, 1983).
The future growth of the level and structure of consumption were affected
most significantly by income growths but also affected by changes in price
structure and by shifts in tastes over time, rising level of living and the availability
of new products, increasing urbanisation of population, changes in other
demographic features of households like age, sex, composition, geographical
location, occupation and other distributional change.
The second approach was called family budget study. The early studies
of the consumption income relationship have been done by Earnest Engel (18211896) statistician in the government of Saxony. His name has became famous
through the formulation of two laws. The poorer the family the greater the
proportions of total spending which goes for food purchase. He inferred from this
that the proportion spent on physical needs represents the material well being of a
people. His other law states that luxury spending occurs only at a higher income


level when the basic necessities have been met. Today the term Engel curve is
used to denote families of curves which show the functional relationship between
consumption of a good against income, other things being equal.
1.13.2 Macro economic theories
The post war efforts to re- specify the consumption theory are found in
macroeconomic formulations of Consumption Function. Since Classical
Economist lived in the world of full employment the volume of consumption
expenditure was not of prime importance in their analysis. Consumer maximises
his utility within the budget constraint and emphasis is on the price variables in
the resultant demand function. However, some classical works do talk of
consumption function. Pigou (1952) and Marshall admit the existence of a
relation between aggregate income and saving but the significance arise only in
the course of long run growth and not in the short run variables.
Absolute income hypothesis of Keynes
It was (Keynes) who formulated the consumption function in a specific
and systematic form. This served as a corner stone of Keynesian theoretical
structure (Gupta, 1986) . Keynes fundamental psychological law was the first
serious formulation of the consumption function. The law states that as income
increases consumption also increases but not by as much.
Keynes theory of consumption function summarises the following

The propensity to consume is a fairly stable function, so that as a rule,

the amount of aggregate consumption mainly depends on the amount of
aggregate income.


Men are disposed as a rule and on average to increase their consumption

as their income increases but not by as much as the increase in their


A higher absolute level of income will tend as a rule to widen the gap
between income and consumption because the satisfaction of the


immediate primary needs of a man and his family is usually a stronger

motive towards accumulation which only acquires effective sway when
a margin of comfort has been attained.

A rising income will often be accompanied by increased saving and

falling income by decreased saving on a greater scale at first than
A simple linear version of Consumption Function is
C= a + by + u
Where a> 0, 0< b<1

is a random disturbance term, b is the Marginal Propensity to

Consume and it does not differentiate the long run and short run Marginal
Propensity to Consume . The wealth effects are not included. C/y is the ratio of
consumption to income or average propensity to consume which declined with
increase in income
Standard Keynesian Doctrine was first challenged shortly after the II world
war (Timbrell, M C (1976).
A number of variants of the simple Absolute income Hypothesis were
estimated using various sources of data and the results were far from encouraging
and the forecast very poor.
(Davis, 1952) analysed the predictive ability of a number of CF fitted to US
data ( 1929- 40)
Brady and Friedman (1957) on the household budget data demonstrated
that although consumption function has a positive intercept and hence the MPC
was less than the Average Propensity to Consume (APC) the intercept shifted
upwards over time.
Smithies (1945) used a time trend to capture a ratchet- like effect in his
analysis of annual series data but the most important results were produced by
Kuznets. Kuznets (1942) demonstrated that over fairly long periods the APC was
high and stable while the MPC was lower than the average, lower in the short than


the long run and tended to fluctuate in value particularly during the war period.
Absolute income hypothesis was incapable of explaining the apparent
contradictions. The credibility of Keynesian theory was weakened because it
failed to predict the post war demand in India. These empirical evidences lead to
the search for new theories of consumption behaviour resulting in three major
Relative Income Hypothesis
Deusenbery (1949) formulated his theory Relative Income hypothesis as
a reconciliation effort on the basis of habit persistence hypothesis, stating that the
consumption behaviour was interdependent and consumption relations were
irreversible overtime. He argued that consumption of an individual not only
depends on his absolute income but also on the past level of consumption. It was
difficult to reduce previously attained higher level of consumption than to reduce
the saving. This reflected the cyclical behaviour of C/y. The theory explained
both time series and cross-section formulations of consumption behaviour
The Relative Income hypothesis was formulated as
C/y = a+b (y/yo),b<o
Where yo was Peak previous income. Therefore the predicted values of c/y
from this function were higher in recessions. In the long run
Yo= Yt-1

Y/Yo (1+y)

( = some constant)

Where y was the growth rate of income per unit of time Thus c/y= a
constant term in the long run.
The habit persistent Hypothesis
Developed by Brown (1952) assumes a continuous influence of past
consumption habits and previous consumption is taken as the relevant lagged
variable. According to him habits, customs, standards and levels associated with
real consumption previously enjoyed become impressed on the human
physiological and psychological systems and this produce an inertia in consumer


behaviour. Also, the shorter the time lags the stronger is the effect of habit
The Permanent Income Hypothesis
Friedman( 1957) formulated the theory of Permanent Income Hypothesis.
Peoples consumption depends not only on the income they actually receive in
the current period but also on the income they expect to receive on a continuing
Let Y represent a consumer units measured income for some time period,
say a year. This income is the sum of two components. Permanent component
(Yp) and transitory component (Yt) or Yp+Yt.
The permanent component was interpreted as reflecting the effect of those
factors that the unit regards as determining its capital value or wealth, the
nonhuman wealth it owns, the personal attributes of the earners in the unit, such
as their training, ability, personality, the attributes of the economic activity of the
earners such as the occupation followed the location of economic activity and so
on. It was analogous to the expected value of probability distribution.
The transitory components was to be interpreted as reflecting all other
factors that were likely to be treated by the unit affected as accidental or chance
occurrences though they may from any other point of view, be the predictable
effect of specific forces, for example cyclical fluctuations in economic activity. In
statistical data the transitory component included also chance errors of
measurement. Similarly let C represent a consumer unit, it was regarded as the
sum of a permanent component (CP) and a transitory component ( Ct), so that,
C= Cp+Ct. Friedman took the expenditure on durables as investment and services
as derived from stocks of durables in CP. So CP = KYP.
The function had no intercept. Accordingly Brown (1952) introduced a new
approach to consumer behaviour. He cited that customs and habits influence
consumer behaviour. It implies that change in consumption expenditure was
comparatively slow to the changes in their income. He took the lagged variable as
previous consumption instead previous income.


Ct = a + b Yt + d Ct- 1
But Friedman found lags in consumer behaviour. He made a clear
distinction between income actually received (measured) and income for actual
consumption (permanent income)
Permanent income hypothesis was tested empirically for time series and
cross section evidence by Klein(1958), Drake (1964), Modigliani and Ando
(1960), Bodkin (1959), Mayer (1966).
The Life Cycle Hypothesis
Life cycle hypothesis was developed independently from the permanent
income hypothesis. This was the contribution of Modigliani, Brumberg, Ando and
Modigliani (1963). The typical consumer had to choose a consumption stream to
maximize a utility function defined on present and future consumption, which was
subject to a life time resource constraint and which was itself stable over time.
The underlying argument of consumption function was that consumption
depends on the resource available to the consumer over his entire life span, the
rate of return on capital and the age of the consumer.
Available resources mean existing net wealth plus the present value of all
current and future non property earnings (labour earnings). Accordingly a
consumer allocates his income, accounting all his present resources, to maximize
utility over his life time. Thus an increase in income will add to consumption, to
the extent it adds to total life time resources. Obviously, the consumption depends
on these resources (labour and property) instead of current income.
The life cycle Hypothesis can be illustrated as

CtT= KtT (y L ) Tt + (N T)YLe ) Tt + WtT1 _________(1)

Where t is the time period,
T= present age of the consumer.
N= Earning period of the consumer.
K= constant of proportionality.


YL= current labour income of an individual.

YeL= expected future income (labour) of the individual
w= Net wealth of the individual
Equation (1) can be written as

Ct= a1 (YL)t + a2 ( (Y ) t+ a3 Wt -1 _______ (2)

Underlined letters are aggregate of individuals
Eqn (2) is in the aggregate form.
Thus in the consumption function taken as a function of income and
wealth, the long period marginal propensity to consumer was determined and it
was equal to the APC. Several empirical tests were made to examine the
consumption behaviour in this perspective.
Besides there are several other types of hypotheses such as Normal Income
hypothesis, Proportionality hypothesis and Rate of Growth hypothesis.

1.14 New Model

The principal development in consumption theory in the last 15 years or so,
starting with

Zelders (1984) is that, spectacular

advances in computer speed

have allowed economists to determine optimal behaviour under realistic

assumptions about uncertainty. A preliminary step was to determine the
characteristics of the

income uncertainty that typical households face. Using

annual income data for working-age households

Carrol (1991) found the

uncertainty of the consumption function which implies that impatient consumers

will engage in buffer-stock saving behaviour. That is there will be some target
level of the cash-on-hand ratio such that, if actual cash-on-hand is greater than the
target, impatience will outweigh prudence and wealth will fall, while if cash-onhand is below the target, the precautionary saving motive will outweigh
impatience and consumers will try to build wealth back up towards the target .
Buffer stock saving behaviour is a qualitative implication of the model. Perhaps
the most striking feature of the converged consumption function is that the


Marginal Propensity to Consume (the slope of the CF) is much greater at low
levels of cash on-hand than at high levels. In other words, the converged
Consumption Function is strongly concave. Thus

the first

intuitive result that

comes out of the analysis is that, as Keynes (1935) argued long ago, rich people
spent a smaller proportion of any transitory shock to the income than poor people.

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