Importance of the Consumption Function
Importance of the Consumption function
Consumption function is not to be considered merely a subject of study and analysis. It has a great theoretical and practical importance. All countries want to remove unemployment from their midst, raise their national income and enjoy prosperity. For this purpose a policy of planned economic development is essential. In the formulation of this policy, consumption function plays a very useful role.
We briefly discuss below the importance of consumption from various points of view:
1. Important Tool of Macro-economic Analysis. Consumption function is an important tool of macro-economic analysis given to us by Keynes. Without the consumption function, we would not have been able to find a determinate link between changes in investment and the resultant changes in income of a country. From this point of view, for the macro-economic theory, the consumption function is as important a tool as the demand and supply functions is in the theory of firm and the industry.
2. The Value of the Multiplier. From the consumption function, we derive the value of the multiplier, which as we have known are equal to1/ 1-mpc. Here MPC is marginal propensity to consume. Since marginal propensity to consume is less than unity, an initial injection of purchasing power into the income stream leads to a multiple expansion of total income in a peculiar way. That is, original' injection of money into the economy leads to several successive increments of income in the course of responding 10 the increase in original purchasing power. The multiplier gives us a quantitative link between changes in investment and changes in income. If, for example, the marginal propensity to consume is f, we know that the multiplier will be 4 so that if investment increases by say, Rs.-1,000, national income will rise by Rs.-4,000. Even before Keynes, the economists knew that changes in investment bring about changes in income but by how much and through which process was not clear, till Keynes gave us tools of consumption function and the multiplier.
3. Invalidates Say's Law. Consumption function helps to invalidate Say's Law which said that supply creates its own demand. Since marginal propensity to consume is less than unity, the whole of the income is not spent on the output produced. According to Say's Law, general over-production in the country is not possible since supply is supposed to create its own demand. This law may hold good in the long run, but not in the short run. In the long run, the market forces establish equilibrium automatically so that demand may be equated to supply. But no such automatic adjustment is possible in the short run. Hence, for some time there may occur general overproduction. According to Say's Law, an act of producing is simultaneously an act of creating proportional effective demand. There is no doubt production creates value equal to itself but that value is not wholly spent then and there. Since marginal propensity to consume is less than unity, the classical law of markets does not hold good, because the entire output cannot be taken off the market or the entire income is not spent. We knew that marginal propensity to consume is less than unity, i.e., as income increases, consumption increases less than increase in income. Hence, supply, far from creating its own demand, exceeds demand and creates a glut in the market which means general overproduction and mass unemployment.
4. Shows Crucial Importance of Investment. Consumption function also underlines the crucial importance of investment. Because propensity to consume is stable, employment can be created only by increasing investment. Consumption function tells us that people spend proportionately less than the increase in their income. Therefore, it becomes necessary to fill the gap between income and consumption by increasing investment; otherwise it will not be profitable to increase output and employment. We also know that consumption function is more or less stable. Hence, it is instability of investment which is responsible for fluctuations in income and employment in a country. It is, therefore, clear that investment plays a vital role in increasing income and employment in a country. If propensity of consumption could also increase, income and employment could be increased even without increasing investment. But, since consumption function is stable, investment is the crucial and initiating determinant of the levels of income and employment.
5. Explains the Declining Marginal Efficiency of Capital. Consumption function explains the declining marginal efficiency of capital. Since consumption function does not increase which could raise the level of consumption expenditure, the prospective yield of capital assets falls. Once the demand for capital goods decreases, the marginal productivity of capital cannot rise unless the marginal propensity to consume rises. Thus, the fall in the marginal productivity could be checked, if the marginal propensity to consume could be increased. Hence, the marginal efficiency tends to decline because the demand for goods is discouraged on account of the marginal propensity to consume not rising or the marginal propensity to save not falling. It is the stability of the marginal propensity to consume which explains the declining marginal efficiency of capital.
6. Explain the Turning Points of the Business Cycle. Consumption the turning points of the business cycle. The trade cycle takes the downward course because the marginal propensity to consume is less than unity, i.e. the people do not spend proportionately more as their income increases similarly, and the consumption function explains the upturn of the business cycle. This is due to the fact that since consumption is stable, people are unable to cut down their consumption expenditure to the full extent of a decrease in their income. It shows the danger of permanent over-saving gap and thus explains the secular decline in the marginal efficiency of capital.
Thus, consumption function occupies a very important place in the theory of employment.