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What is a Consumption Function?

John Lister
John Lister

The consumption function is an attempt to express, in a mathematical manner, the way in which consumer spending works. It is based on two types of spending: autonomous spending that is constant, and induced spending that varies with income levels. Critics of the consumption function suggest it does not take account of future income.

There are several ways to express the consumption function, but they all involve adding two figures. One figure is simply the autonomous spending. The other figure is the disposable income available to consumers multiplied by the proportion of disposable income that is spent on induced spending, which is spending is that which varies with income levels. It could include goods and services seen as luxuries, but can also include buying better quality products used for basic needs.

John Maynard Keynes.
John Maynard Keynes.

Autonomous spending is the spending that remains the same regardless of people's income. In theory, this would include spending on essentials such as rent or mortgage payments, basic food, and clothing. It is possible for the total of autonomous spending to be greater than the total of income. This would happen where the economy was in rough shape and, taken as an overall average, people were relying on savings or borrowing to fund their basic needs.

The consumption function uses a measure known as the marginal propensity to consumer. This measures how much of any income rise consumers are likely to spend. Most economists believe this is not a constant factor, but rather one that declines with income. This means that although consumer spending rises with income, it does not rise as rapidly. This is because the more money people have, the more likely they are to feel their needs are met and be in a position to decide against "wasteful" additional spending.

The consumption function is also known as the absolute income hypothesis. It was originally developed by economist John Maynard Keynes in the early 20th century. Modern studies find it is a reliable guide in the short term, but does not prove so accurate over the long term.

There are several theories that attempt to correct this shortcoming. The permanent income hypothesis takes account of people being more likely to borrow money for "unnecessary" spending because they expect to fund it from future income, whether that be payraises over their working life or windfalls, such as inheritance. The life cycle hypothesis works on similar lines and suggests that a consumer's annual spending makes up a stable percentage of the total income he expects to get over his lifetime, taking into account retirement.

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    • John Maynard Keynes.
      John Maynard Keynes.