Consumption And Investment

CONSUMPTION FUNCTION AND INVESTMENT FUNCTION. Consumption Function Psychological law of consumption Consumption means using goods and services for satisfying current wants. We spend major portion of our income on consumption. Consumption expenditure means house hold spending which satisfies our immediate wants. Under this section we will study the relationship between consumption and income. The pattern of consumption expenditure for all families is more or less the same. We can see that families have tendencies to increase consumption with increase in income. This relationship between consumption and income is called Consumption Function. Consumption is a function of income. MPC – Marginal Propensity to Consume, the ratio of change in total consumption to change in total income. It says that when income increase, the consumption will increase but less than the increase in income. This is called the Psychological law of consumption because people do not consume all the increase in the income in the current period because they have to save for their future. This consumption behavior of a family helps us to understand community behavior. J. M. Keynes introduced the concept of consumption function at macro level as aggregate consumption function. Relationship between MPC & APC. Aggregate consumption function is relationship between planned or desired consumption expenditure and level of nation income (NI). Determinant of consumption:There are two groups of factors that effect consumption function. Subjective or internal factors. These are related to psychological characteristics of human wants. These factor changes more in long run rather than short run. These factors are; a. Precaution motive – Every individual has a strong feeling to prepare for unseen emergencies like sickness, accident, unemployment etc. So they build up reserves for such emergencies. b. Foresight motive – Every man has future needs. They need to save for old age, educational needs of children, Marriages of daughters etc. c. Motive for independence – Most of us have a strong desire to be independent financially. So we tend to save by sacrificing present consumption. d. Standard of living – We always want to improve the standard of living for which we reduce the consumption and save for future.

e. Status Motive – People feel socially upgraded if they are financially strong more wealth means higher status or pride. 2. Objective or External factors a. Distribution of income.-this is an important factor in of propensity to consume. The more inequality in income distribution the propensity to consume will be low. Equal distribution of income increases the propensity to consume. Poor people have higher MPC as their basic or primary needs are not satisfied. So increase in income tends to increase in MPC, where as rich people have lower MPC. b. Expectations – Every consumer has certain calculations about their future changes. This may be regarding the price, income or employment. When they expect price increase in the future they tend to consume now or if they expect unemployment in future they tend to consume less and save more. c. Windfall gains or losses – When consumer gets huge profit they tend to consume more as income increases where as loss will make them consume less due to decrease in income. d. Fiscal policies - Fiscal policy is related to tax structure and government expenditure. When the taxes are decreased the disposable income with people will increase and so the consumption and vice versa. e. Stock of wealth – If any individual has enough stock of wealth in the form of bonds, fixed deposits etc., he tends to consume more from his current income. But if the stock of wealth is low the individual will spend less and tend to save more Practical significance of Consumption Function 1. Useful in firms and business The concept of APC and MPC are useful in estimating demand for products in future. The estimation of future demand is important for decisions like expansion, diversification and modernization. If the MPC is high, business men know that the demand for the product is likely to increase. But if the MPC is low, the demand will decrease. 2. Helps in explaining Business Cycle. Business Cycles are the upswings and downswings in economic activity. The phases from depression to recovery than from expansion to recession are set by consumption function. The decline in MPC undermines the prosperity phase and gives way to recession. But MPC will not fall in the same ratio as decrease in income and Depression is arrested through MPC. 3. It is the base for Multiplier. MPC is base for Multiplier. The process of Multiplier explains the income increase and relationship with MPC. Multiplier is explained in detail in the coming section of investment function.

Multiplier: Multiplier concept is associated with R. F. Kahn. He said that whenever the government takes up some public works this leads to employment opportunities in the economy which is called a employment Multiplier. Later on, this concept was developed by Keyens. He said this concept is based on a simple logic; one man’s expenditure is another man’s source of income. So a small autonomous investment leads to multiple increase in income. Definition of Multiplier:- The ratio of change in National Income resulting from change in autonomous investment .We assume that the investment here is autonomous investment that is government investment. Multiplier says an initial autonomous investment leads to multiple increase in income. MPC, MPS and Multiplier. Consumption Function is the basis for Multiplier. Whenever the income increase the consumption also increase. The increase in the demand needs an increase in the supply and so that employment also increases therefore income increases. Let us see the value of Multiplier. If the MPC is 100% that is when the income increase, it leads to increase in consumption by same amount. The Multiplier will be infinite. So when MPC = 1 Multiplier will be infinite. This is because when consumption increase there is a increase in demand and so increase in employment to increase the supply. If the MPC is 0 that is an increase income has no increase in conception that means people save the entire increase in income. The Multiplier will be 1. That is when MPC = 0, K = 1 But in real life, MPC is always more than 0 and less than 1. So the Multiplier value will be greater than 1 but less than infinity. So the value of Multiplier is used by the following formula To summarize the relation between MPC and Multiplier you have to remember three points >Higher MPC, K is stronger >Lower MPC, K is weaker >MPC = 0, K=1 > MPC = 1, K is infinite Assumptions: 1. 2.

Autonomous investment: - The investment is assumed to be autonomous investment that is for public work taken up by the government. Availability of idle capacity : -The Multiplier will work only if there is excess capacity in the economy so that due to investment when the demand increase

3.

4. 5.

there is capacity to increase the supply or else only the price will rise and lead to inflation. No leakages: - If there is foreign trade then increase in income is used for buying imported goods. Multiplier effect will increase the demand for foreign goods and go outside the country .So the full value of Multiplier cannot be realized in an open economy. No time lag: - It is assumed that there will not be enough gaps between income and consumption expenditure to have Multiplier effect. There is not much change in stabilization policies. It is assumed that there no change in monitory and fiscal policy because when these policies changes there is change in the MPC of consumers which leads to change in value of Multiplier.

Significance of Multiplier: This concept is not just theoretically important but also has practical significance. 1. Public investment – Multiplier show a strong case of government investment. In case of depression the government investment is really important and gives positive effect through Multiplier. Because of small investment there is multiple increases in income in an economy. 2. Useful in planning employment policies: - This is useful in framing a national employment policy. It helps estimating how much government expenditure or autonomous investment is required to reach full employment because whenever there is small investment made the income and demand increase and so the employment. 3. Forecasting demand in response to government expenditure:- Multiplier is useful to government to bring about the change in aggregate demand and aggregate consumption in response to its autonomous investment. If MPC is 0.80 and government undertakes autonomous investment of Rs.100 Cr the aggregate demand will be higher by Rs.500 Cr. National Income increase and aggregate demand consumption increases and aggregate consumption increases by 400Crs. This information is important not only for government but also businessmen. Investment Function In the previous section, we discussed Consumption Function. We will now start the second important concept that is investment. Investment here means capital expenditure i.e. the expenditure on purchasing physical assets, machinery, equipments etc. Items that helps to increase productive capacity and output. Types of Investments. We will first discuss the types of investment:1. Gross and Net investment- Gross is total value of productive assets created during a

given period say one year. It tells us the resources mobilized by the economy. Depreciation is part of gross investment. When we deduct amount of depreciation from gross investment we get net investment. Net investment creates new productive capacity and employment opportunity. 2. Private investment and Public investment- Investments made by private companies and corporate comes under private investment. Investment made by Government and departmental undertakings is called public investment. 3. Induced and Autonomous investment- Autonomous investment is the investment which is income in elastic, which means even is the income is zero there is some amount of investment done by the Government. It does not depend on the change in the National Income.

In this figure IX-2.1(2) income is shown on x-axis and investment is shown on y-axis. You can see that even when the income is zero, some amount of investment is made. Induced investment increases with increase in income and decreases with the decrease in income.

In this figure IX – 2.1(3) income is shown on x-axis and investment is shown on y-axis. You can see when income increases the demand and consumption will increase and so the investment to increase the production and supply and vice versa.

In this figure IX- 2.1(4) income is shown on x-axis and investment is shown on y-axis. We can see the total investment in the above figure. Total investment = Autonomous investment + Induced investment Factors affecting investment. There are some factors which affect investment. 1. Investment and rate of interest- Rate of interest is considered most important factor in investment decisions. If the rate of interest increases, the investment will be low and vice-versa. This was a view given by classical economists. They considered rate of interest as the only factor determining investment. 2. Marginal Efficiency of Capital (MEC) – Any investment decision depends not only on rate of interest but also whether or not the expected rate of returns on the investment is greater than cost of borrowing the funds. In these two factors the MEC is an important factor because MEC is the expected rate of returns from the investment. If the returns expected are low then the investment is not profitable because in short run, rate of interest is stable. In MEC, capital means the real productive assets. MEC depends on expected rate of returns of a capital asset over its life time which is also called Prospective Yield and the supply price of capital assets. Any business man will weigh the prospective yield with the supply price before investing. 1. Prospective yield 2. Supply price. 1. Prospective yield – Induced investment is based on profit motive. Businessmen are always interested in knowing how much money he can earn by investing in new productive assets. The concept of prospective yield is related with the amount of money a businessmen will get from selling the final product produced by the new amount of capital. In this again, there are two things. First, the life of the asset as in the above example, we have given the life of 4 years. Second, the businessmen is interested in knowing the yield or revenue during the lifetime of the machine, which we have shown Rs 7,000/- every year. The new machine will not give the same yield every year. That is why it is shown as Q1,Q2 ,Q3 as prospective yields for the 1st, 2nd and so on. These yields are purely imaginary and it is the expectation and calculation of the business. 2. Supply Price - The next important valuable is the supply price which is the present value of capital asset. To summaries the whole theory. We should remember these points to calculate profit of interest. -

Supply price of capital Technical life of capital assets

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Estimate the annual prospective yield from capital assets.

MEC, Rate of interest and investment decisions. The businessmen will decide whether to purchase on the marginal unit of capital by comparing the prevailing rate of interest with the MEC. • • •

If MEC >Rate of interest, this additional investment will get profit and investment is profitable. MEC < Rate of interest. The additional investment will get loss and investment is not profitable. MEC = Rate of interest. There is neither gain nor loss from the investment that means investment expenditure will come to halt.

Factors effecting MEC – There are some short term and some long term factors. Short term: - Under these the factors are 1. Expected demand for future:- If the demand is expected to increase ,the MEC will be higher. If the businessmen feels that the demand will decrease in future, the prospective yield will be low and so the MEC. So the change in expectation gives sudden ups and downs in investment decisions. 2. Level of income:- When people experience gains through reduction in tax or gains in bullish market, the businessmen become more optimistic as they know when income increase ,the demand will increase and so the MEC is high and it is the other way when there are huge losses. 3. When consumption changes:- In real life whenever there is a shift in consumption function the MEC also changes. E.g. If consumption increase in current income then the businessmen find investment profitable as the demand will increase and so MEC is high and vice versa. 4. Business expectation:- Investment is something which gives returns only in the future. Any decision on investment depends on the return which the businessmen expects in future. If the environment is optimistic that leads to more expectations in future. Long term factors:1. Population growth:- Whenever there is increase in population , there is increase in demand also. This means the consumer goods demand increases and so the demand for capital goods also increases. To increase the capital goods there is need to invest more this increases the expected rate of returns or prospective yield and so the MEC is high.

2. Economic Policies of government:- The long term government also effects the MEC as in 1991 after the liberalization and globalization, the prospective yields and MEC increased. Such types of policies make the businessmen more optimistic and encouraging. 3. Infrastructures facilities: - If the infrastructure facilities are more developing, adequate and uninterrupted , the calculation of MEC will be higher. Limitations of MEC:1. Investment done by the Government for social purpose has no connection with the MEC. 2. Practically it is difficult to estimate MEC. 3. Whenever there is contractionary monetary policy the firms may not find funds even if the projects or investments are profitable 4. Every time the businessmen do not necessarily go for loans. Sufficient funds are gathered by the businessmen for some projects which are planned for a long time. MEC and Business Expectation MEC depends on the businessmen’s expectations which increases due to invention and goes down due to any threat to the returns on investment. It is also affected by the annual spirit of the entrepreneur. That is why investments are not always calculations but also irrational optimism. Business expectations are based on existing events and partly future facts. The investment decision is not done on actual investment but on the future yields. Therefore huge expenditure is required but actual returns starts later. These two types of expectations short term and long terms are based on existing facts whereas long term expectation is based on the future events. IX 2.4 Acceleration Principles: The Multiplier and Acceleration Principle are parallel concepts. This principle is also called Principle of Acceleration. • Multiplier shows the effect of consumption on investment. • Acceleration shows the effect of investment on consumption. This is so because to produce the final goods, capital goods are also required. Therefore, if you want to increase the final product, the capital goods which are inputs for these final goods should also be increased. When consumption increases, the demand for factors of production will also increases. Acceleration measures the change in investment good industries as a result of change in consumption goods industries . Eg. If there is an expenditure of Rs. 20 Cr. on consumption goods, it leads to an investment of Rs.40 Cr in investment goods industries, then acceleration is 2. Acceleration is usually more than 0.

We will now summarize the difference between Multiplier and acceleration. • • •

‘K’ shows effect of change in investment on income and employment where as ‘a’ shows the effect of change in consumption on investment. ‘K’ depends on propensity to consume and acceleration depends on durability of machine. ‘K’ depends on psychological factors, whereas acceleration depends on technological factors.

There are certain practical limitations in this principle. 1. No excess capacity: - If consumer goods sectors have excess capacity induced investment will not increase. Only after the utilization of idle capacity the principle will start operating. 2. Surplus capacity:- Acceleration principle works on a very tough condition that there will be excess capacity in investment industry but not in the industry producing consumer goods. It is assumed that there is surplus capacity in investment goods industry, but if there is no excess capacity in machine making industries there will be postponed delivery and the acceleration will be low. 3. Availability of resources :-when demand increase for capital goods that means increase in production which again means more employment. So there should be enough unemployed resources available. But only when the full employment level is reached there is difficulty in expanding the production. 4. Nature of Demand: - The demand for consumption good should be more or less permanent for acceleration principle to work because if the demand increase is temporary, then that will not increase demand for capital goods as these goods are expensive.