Keynes’ Psychological Law of Consumption

Keynes’ psychological Law of Consumption is an important tool of economic analysis in Keynesian economics. Keynes propounded the fundamental psychological law of consumption which forms the basis of the consumption function. The law implies that there is a tendency on the part of the people to spend on consumption less than the full increment of income. Therefore, this law is called fundamental law of consumption or psychological law of consumption. In other words, the law states that aggregate consumption is a function of aggregate disposable income. According to Keynes, consumption function shows the functional relationship between income and consumption. It explains the nature of propensity to consume. According to this law, people have a tendency to spend more on consumption when their income increases, but consumption expenditure won’t increase by same extent as increase in income, because a part of increased income is saved. This law states that, “The psychology of the community is such that when aggregate real income is increased, aggregate consumption is increased, but not by so much as income”. The psychology of the community is determined by people’s habit, custom and tradition. This law way popularly known as ‘propensity to consume’ and subsequent writers called it ‘consumption function’.

Keynes’ psychological law of consumption depends upon three related propositions:

(i)   When the aggregate income increases, consumption expenditure will also increase by a somewhat smaller amount;

(ii)  An increment of income will be divided in some ratio between saving and spending;

(iii) An increase in income is unlikely to lead either to less spending or less saving than before.

Above given all the propositions of this law means that consumption essentially depends upon income and that income receivers always have a tendency to spend less on consumption than the increment in income.

Assumptions

Keynesian psychological law of consumption is based on the following assumptions:

(i)   Short-period: This law is related to the short-run because in the short-run distribution of income, price level, population growth, fashion, tastes, behaviour, etc., won’t change. Consumption will only depend upon income.

(ii)  Normal Situation: There should be a normal situation in the economy for the application of this law. In such a situation, war, revolution, hyperinflation, etc., should not be occur.

(iii) Laissez-faire Capitalistic Economy: It assumes the existence of a laissez-faire capitalistic economy. It means, this law only operates in a developed capitalistic economy where there is not any kind of government interference. That is, this law won’t be applicable if government intervention occurs.

The main proposition of Keynesian psychological law of consumption can be illustrated by the following hypothetical consumption schedule:

 

Schedule of Consumption and Income

[Rs. in Crores]

Income (Y) Consumption (C) C=f(y) Saving (S) S=Y-C
100 70 30
120 80 40
140 90 50
160 100 60
180 105 75
200 110 90

In above table, when income increases, the consumption also increases but less than income. When income increases from Rs. 100 crores to Rs. 120 crores, then consumption expenditure also increases from Rs. 70 crores to Rs. 80 crores. It means that income in creased by Rs. 20 crores but consumption increased by Rs. 10 crores only, because of some part of increased income is saved.

Diagrammatically presentation of the law

In the figure, when income increases from OY to OY1, Consumption also increases from EY0 to C1Y1, but the increase in consumption is less than the increase in income, i.e., C1Y1<CY. Similarly, when income increases from OY1 to OY2, consumption also increases from C1Y1 to C2Y2 and increased saving A2C2>A1C1.

Thus, Keynesian psychological law of consumption explains about the psychology of community towards expenditure pattern that the consumption function measures not only the amount spent on consumption but also the amount saved.

 

Determinants of Consumption Function

The factors which determine the level of consumption is called determinants of consumption. J.M. Keynes mentions two principal factors which influence the consumption function and determine its nature (slope) and position. They are: subjective factors, and objective factors.

  1. Subjective Features:

The subjective factors affecting propensity to consume consists of those psychological motives. Therefore, subjective factors are also known as psychological factors because these are internal factors that determine the consumption function. These factors are related to human behaviour and habits, social customs and traditions. There are different motives of consumers, which lead to determine the level of consumption.

(i)   Demonstration motives:

If consumers are influenced by the consumption of other people and try to adopt similar consumption practices, such practices are known as demonstration effect. If the people of a country are affected by the demonstration effect, then the propensity to consume will be high and if not affected by the demonstration effect, then the propensity to consume will be low. Advertisement, fashion, luxurious life style, etc. are able to influence consumption pattern of the people.

(ii)  Security motives:

The families and individuals in the modern industrialised societies are highly conscious with old age, sickness and other unforeseen contingencies related to economic insecurity. Hence, people try to save quite regularly. Such savings reduce the consumption function.

(iii) Business motives:

Business motive is one of the most important factors determining consumption function. Due to business motives the individuals and government cut down their current consumption. The business motive mainly influences the propensity to save of corporations and various business units. The uncertainty regarding the future, the quantity and quality of existing equipments, and other conditions give rise to motive for withholding a part of current earning which, in turn, reduces the consumption function.

(iv) Improvement and Development motive:

Improvement and development motives of the country and individuals also influence the pattern of consumption function. If the people would like to develop and improve their life and society, then they are ready to sacrifice a part of their present consumption. Therefore, improvement motive is one of effective factors to determine consumption function.

 

  1. Objective Factors:

Important objective factors which cause changes in the nature, shape and position of consumption are as follows:

(i)   Income:

Income is the most important factor that determines a community’s propensity to consume. As its income rises or falls, consumption also rises and falls.

(ii)  Distribution of income:

Another factor determining how much will be spent for consumption out of a given income of the community is the way in which income is distributed. There is great inequality in the distribution of income in the modern capitalist societies with the result that the rich find it easy to save. This widespread inequality of income lowers the overall propensity to consume as the rich have already fulfilled most of their basic wants. A more equal distribution of wealth will raise the propensity to consume.

(iii) Fiscal Policy:

The fiscal policy of government relating to taxation, expenditure and public debt have significant effects on the consumption function. The Government’s fiscal policy resulting in highly progressive tax system brings about more equitable distribution of income which increases propensity to consume. On the other hand, a regressing tax structure will reduce total consumption in the economy.

(iv) Windfall Gains or Losses:

Sudden and unexpected gains and losses in income affect consumption accordingly. If windfall gains increases unexpectedly, then consumption will also increases and if losses increases, then propensity to consume will decrease. In the late twenties, there were huge windfall gains on account of the boom conditions in the American economy and consumption function shifted upwards.

(v)  Changes in the rate of interest:

Changes in the rate of interest may also alter the propensity to consume though the direction of change is not certain. If the rate of interest goes up, people will consume less and save more in order to gain from lending on the higher rate of interest. On the other hand, people may consume more and save less with a fall in the rate of interest. Further, a person who desires a fixed income in future is likely to save less at a higher rate of interest than at a lower rate of interest.

(vi) Financial policies of corporations:

The policies of joint stock companies and corporations with respect to dividend payments and investment also affect consumption in various ways. If corporations and companies keep more reserves and distribute less of their profits as dividends, it will lower the disposable income with consumers. On the other hand, if more income is distributed in the form of dividends more will be spend on consumption.

 

Measures to Raise the Propensity to Consume

In the short period due to psychological and institutional factors, it is very difficult to stimulate consumption function which possible in long-run measures to raise propensity to consume in long run are as follows:

  1. Income Redistribution:

Propensity to consume of poor people is higher than propensity to consume of rich people. Therefore, redistribution of income helps to raise propensity to consume if redistribution of income favours poor. Thus, propensity to consume can be raised transferring income from the rich to poor.

  1. Social security:

Various type of social security measures raise propensity to consume in long run. For example provision for unemployment compensation, old age allowance, widow allowance, etc., remove uncertainties in future. Therefore, tendency to save is reduced and people start to consume more.

(3)  Wage policy:

Wage rates are considered measure to raise consumption in both short-run and long-run point of view. But in short run, labour productivity can’t be increased more will harm the labours more than benefit because increased wages will increase cost which may lead to unemployment. Thus in long-run, if wage rate and productivity of labour both are increased in same way then it will tend to raise level of consumption in economy.

(4)  Easy credit facilities:

Consumption function shifts upward by the help of cheap and easy credit facilities.

(5)  Advertisement and publicity:

In modern time, advertisement and publicity, propaganda and salesmanship are effective tools to attract consumers towards commodities because these make the consumers familiar with use of product. It raises consumption function of people.

(6)  Development of infrastructures:

            Development of infrastructures like transport, communication, hydropower, etc., helps to shift consumption function upward.

(7)  Urbanization:

In urban areas people are highly influenced by the demonstration effect. This shifts the consumption function upward.

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