Matter of the Consumption Function

The idea of examining the actions of individuals in order to solve the certain problems that were observed on macro sphere was a product of heterodox economics which indicated the importance of demand side of the economics profession. In this case, there are several consumption function hypotheses which were to propose and demonstrate the factors that affect the consumption level, which also changes the whole situation of employment. Therefore, it is important to consider these hypotheses to be able to understand the economist’s stance over the profession and interpret the real-world data, which is located at the highest importance, if we exclude the Austrian School which generally opposes the empirical studies when it comes to economics, as we infer from the statements of August von Hayek.

Absolute Income Hypothesis

According to this hypothesis, examination of consumption is depended upon the disposable income, which is the income excludes taxes. The construction of absolute income hypothesis was possible with the work of The General Theory of Employment, Interest and Money by John Maynard Keynes. In his work, he indicates that consumption is merely a function of income (real income, not nominal). Though there is a positive relation between these two, the proportion of income increase will not increase the consumption as same amount as income increase (Keynes, 1936 ). In this case the psychological factors that affect the economic agent will come to determine this proportion. This phenomenon is called Marginal Propensity to Consume (MPC) in his book. To explain the absolute income hypothesis briefly, we should be willing to receive the help of mathematical formation of this construction. Let’s say:

C= a+b*Y

• Y= Disposable Income
• C= Consumption
• a= Autonomous Consumption
• b= Marginal Propensity to Consume

 

            

Factor of autonomous consumption is included on the consumption function because humans need to consume a minimum amount of money in order to continue to be alive, in which an individual will have to spend this money even though absence of money, which the redistribution mechanism of government will arise. When it comes to the Marginal Propensity to Consume, the assumption of an individual will increase its consumption as its income increase but not as much as the increase in its income. The factor of Marginal Propensity of Consume will determine what percentage of income will be spent on consumption. And from this information we can also find the Marginal Propensity to Save (MPS), which is the explanation of what proportion of income would be saved by person:

MPS= 1- MPC

   

One of the main critics of this hypothesis came from the conclusions of statistical analysis of American Economist Simon Kuznets on the impact of income change on the consumption level. These different consumption propensities, taken together with the large "long-run" MPC estimated using Kuznets's decade-averaged data, constituted one of the important puzzles leading to the development of the permanent-income, relative-income, and life-cycle hypotheses of consumption, which we will examine (Stock, 1988).

            As it can be observed from graph above, results that gave us from the used data change as the interval of time-series data increases. Indications of Keynes was true in the examination of short-run data analysis, however when the time period of the examined data increases, autonomous consumption will approach to zero and the Marginal Propensity to Consume will become 1, which means all disposable income will be spent on consumption (Miller, 1996). Short term line represents the situation in which the ratio of savings and income decreases as income increases, however, estimates of savings in the United States made by Kuznets for the period since 1899 revealed no rise in the percentage of income saved despite a substantial rise in real income. So, the term “Consumption Puzzle” became a distinctive word which explains the different results that were observed in long-run and short-run data, therefore this opened the gates for the new hypotheses for consumption analysis.

 Permanent Income Hypothesis

            Even though there are different kinds of consumption hypotheses that were proposed, one of the most important one is permanent income hypothesis. Milton Friedman is the responsible economist for the construction of this hypothesis. In his book A Theory of the Consumption Function he rejects the sole idea of income level directly determines the consumption quantity. First of all, he defines the income and consumption differently when we compare with the evaluation of Keynes’s. Both of them are consisted of permanent and transitory parts. Permanent income is represented by the factors which are seen by the individual that have value as a unit, simply the expected value of average income in a lifetime of a person: personal features, wealth it owns and additional information about the profession and exercise of the person. However, the transitory part of the income includes all other factors that are seen as accidental or chance occurrences by the individual such as illness, bad guess and good chance, despite the possibility that these factors might be predictable factors from another point of view (Friedman, 1957). If we formulize these theoretical constructs:

     Y= Yp+ Yt

• Y= Income
• Yp= Permanent Income
• Yt= Transitory Income

C= Cp+ Ct

• C= Consumption
• Cp= Permanent Consumption
• Ct= Transitory Consumption

In the hypothesis of Permanent Income, one will observe that the separation of permanent and transitory components provides the explanation of the reaction of consumers in their consumption behaviour related to the changes in permanent and transitory income. The explanation is that when permanent income increases, individual increases its spending by about as much, but in case of increase in transitory income he will save rather than spend most of the income, which the lottery example would be a good proposition to make it more rational for individuals (Mankiw, 2003).Thus the basic equation that can represent the Permanent Income Hypothesis will be:

C= a*Yp

• C= Consumption
• a=  Fraction of Permanent Income Consumed
• Yp= Permanent Income
  
  

In conclusion, we may create an analogy between the purpose behind the Ricardian Equivalence and the representation of Permanent Income Hypothesis. As it is known that the according to David Ricardo the tax cuts by governments from society will be responded as the future higher tax expectations from public. Thus, the tax cuts that were implemented in order to increase spending level in society might become a null attempt to stimulate the economy. When it comes to Permanent Income Hypothesis, the expectation of individuals in micro level about their average income in their lifetimes will determine their consumption level, which is considered as a rational behaviour by Milton Friedman.

 

Relative Income Hypothesis

            Relative Income Hypothesis, which was put forth by James Duesenberry, revealed and brought several concepts on the examination of aggregate consumption behaviour of public. Main concept of this hypothesis is that rather than viewing consumption behaviour of individuals as a part of the society in a full sense, the factor of social hierarchy and the effect on the consumption behaviour of individuals has to be considered, due to the social fact that the utility one receives is depended function on the one’s consumption type and quantity relative to what and how much others consume. (Duesenberry, 1949). The logic behind this proposition is that people are concerned about their status relative to others who are in the hierarchical category, therefore the consumption analysis should include interpretation of consumption relative to the hierarchical levels.

               This hypothesis is known as it’s the opposition to the Neoclassical perspective of consumption behaviour which requires certain assumptions about individual attitude such as the assumption of every individual’s consumption behaviour is independent of that of every other individual and the assumption of consumption behaviours can be differentiated in time (McCormick, 2018). In demonstration of the logic behind this opposition suppose that a low-income individual has been exposed to better goods than he is currently consuming, he will be vulnerable to consume more in order to consolidate his stance on the social hierarchy, which means the saving rate of this person will decrease. We can infer that in times of recessions, the declining real income of individuals affects the ratio between saving and spending as people will be willing to sacrifice some proportion of their savings to maintain their former standards of livings before the recession. In contrast, an individual who was observing that people which share the same social hierarchy have increased their material well-being will increase its propensity to consume irrespectively of the income level of this individual, which Duesenberry labels it as “Demonstration Effect” (McCormick, 1983).

            If we evaluate these hypotheses, we will conclude that even though these hypotheses presented different propositions, main basic factor that all of the three have admitted that income is a huge determinator on the case of consumption, and on that basis, they have supplied different perspectives in order to interpret the real-world data.

References

Duesenberry, J. (1949). Income, Saving and the Theory of Consumer Behaviour.

Friedman, M. (1957). A Theory of the Consumption Function. In M. Friedman, The Income Hypothesis.

Keynes, J. M. (1936 ). The General Theory of Employment, Interest and Money. In J. M. Keynes, THE PROPENSITY TO CONSUME: I. THE OBJECTIVE FACTORS.

Mankiw, N. G. (2003). Macroeconomics.

McCormick, K. (1983). Duesenberry and Veblen: The Demonstration Effect Revisited. Journal of Economic Issues.

McCormick, K. (2018). James Duesenberry as a Practitioner of Behavioral Economics.

Miller, T. (1996). Explaining Keynes' Theory of Consumption, and Assessing its Strengths and Weaknesses.

Stock, J. H. (1988). A Reexamination of Friedman's Consumption Puzzle. Journal of Business & Economic Statistics.