Wednesday, April 6, 2011

Consumption Function and Savings Function

Before reading this, read: Consumption and Savings

1. Consumption Function
The income identity is Y = C + S (income = consumption + savings)

C = a + b*Y Or, C = a + (ΔC / ΔY)*Y

MPC or Marginal propensity to Consume is "b". Y is the total income and b = ΔC / ΔY
In the diagram, "a" is the minimum consumption necessary to maintain oneself even at zero income. Now suppose the income increases to B. So AC is our familiar ΔY (change in income). Income increases from O to Yo, which is equal to AC. BC measures change in consumption ΔC, which is the resultant increase in consumption due to an increase in income.

2. Savings Function

MPS or Marginal Propensity to Save is "s". Y is the total income and s = ΔS / ΔY

Income multiplied by Marginal Propensity to Save or MPS or "S" will give us the total savings of the community.

Any point below the point B shows negative savings. B is called the break-even point or the point of zero savings. This means at point B, income = consumption and MPC = 1, as because MPS = 0.

The economic rationale is that at low levels of income people consume more than they earn. At a certain minimum level of income, income is exactly equal to consumption. This is the break-even point in consumption, where savings = 0. Thereafter, with every increase in income, savings goes on increasing. Therefore MPS or s = change in savings / change in income = ΔS / ΔY.

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