Psychological law of consumption
The main purpose of every economic activity, be it production or exchange, is consumption.
It is consumption that motivates man to produce. All the production activity would come to a standstill, if there is no consumption. However, such situation is elusive.
Consumption expenditure is a major constituent of aggregate demand in an economy. The level of a community’s expenditure on consumption is determined by a multitude of factors, like, household income, tastes and preferences, current and expected prices, advertising and sales propaganda, taxation, inflation etc. Lord Keynes, however assumed that, in the short run, real consumer spending is primarily determined by current real disposable income.
John Maynard Keynes has explained the consumption behaviour of the household sector through the Psychological Law of Consumption.in his work – The General Theory of Employment, Interest and Money published in 1936. Therefore, this law is also known as “Keynesian psychological law of consumption”. It provides a key part of the consumption foundation upon which Keynesian economics is built.
The law basically captures and understands the essential spending behavior of the household sector. in any capitalistic or mixed economy
Keynes uses the term ‘psychology’ in his law it is not really a law of psychology or of psychological behavior. It is just a basic observation of consumption behavior and consumption expenditure by the households.
The Psychological Law of Consumption states the relationship between income and consumption pattern, such as the changes in the aggregate income of the economy and the expenditures on consumption by the household sector.
The law is thus, a macro framework of the operation of the economy as it applies more to the aggregate economy than to the individuals. Individuals are prone to violate this law from time to time, but the overall economy almost never does.
According to Lord John Maynard Keynes, “current consumption depends upon current disposable income. A rise in income leads to a rise in consumption and a fall in consumption leads to a fall in consumption”. In simple words aggregate consumption is a function of aggregate disposable income. The empirical consumption-income relationship is presented by the consumption function.
The Fundamental Psychological of Consumption
Lord Keynes defines Psychological Law of Consumption in terms of, “The fundamental psychological law, upon which we are entitled to depend with great confidence, both a priori from our knowledge of human nature and from the detailed facts of experience, is that men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in the income.”
Thus, this is also known as propensity to consume.
It simply means that Marginal Propensity to Consume [MPC] and Marginal Propensity to Save [MPS] are positive [greater than zero] but less than unity (>0 but <1).
MPC+MPS = 1
Consumption function is also based on the psychological law of consumption there is apparently no difference between these two, however due to definite importance of this law in the macro-economic analysis this law has been presented separately to make the nature of propensity to consume clear.
Propositions of Psychological law of Consumption
The psychological law of consumption put forward by Keynes, is mainly based on the following three facts:
1. Increased aggregate consumption (by a smaller amount) due to increased aggregate income
When aggregate income increases, aggregate consumption increases but the increase in aggregate consumption is less than increase in aggregate income.
This is because as income increases more and more of our wants get satisfied. When the basic necessities or demand of the people are already fulfilled not as much is again spent on consumption as the increase in income.
Consumption expenditure will no doubt increase with increase in income but less than proportionately and therefore, savings also increase as income increases.
2. Division of the increased income between the consumption and saving:
The second proposition is that when income increases, the increments of income will be always be bifurcated into saving and consumption this really follows from first proposition.
Consumption spending does not increase at the same rate as the increase in income, ie only a part is consumed. Therefore a part of the increased income is saved and ie what is not spent is saved.
Saving is thus the complement of consumption.
Thus, the increased income does get divided between the two in certain proportion and can be showed as:
∆Y= ∆C + ∆S
Where, ∆ = signifies change
∆Y = change in Income
∆C = change in Consumption
∆S = change in Saving
Thus savings create a gap between Income and Consumption.
3. An increase in income will increase both consumption and savings
The third proposition included in Keynes Psychological Law is that as aggregate income increases both consumption spending and savings will increase ie the consumers will spend a little more than before and also save more than before.
It is not possible for savings and consumption to decrease when income increases.
A rise in income will be accompanied by a rise in savings and a fall in income will be accompanied by a fall in savings. The rate of increase or decrease in savings will be greater in the initial stages of increase or decrease in income than in the later stages.
These three prepositions form the basis of Keynes’ psychological law of consumption. As consumption expenditure progressively diminishes when income increases, a gap between income and expenditure arises, ie savings create a gap between Income and Consumption.
This tendency is so deep rooted in people’s habits, customs, and the psychological set up that it is difficult to change in the short run.
Hence, it is impossible to raise the propensity to consume of the people so as to increase the national output, income and employment.
Increasing the volume of investment in an economy can only fill up the gap between income and Consumption.
This law may be considered as a rough indication of the actual macroeconomic behaviour of consumers in the short run.
Keynes psychological law of consumption is limited by the following assumptions.
1. Normal Conditions:
The psychological law applies only under normal economic conditions and when there is no danger of war or cold war, depression, boom, political upheaval, revolution inflation etc in the economy.
2. The propensity to consume remains stable
The propensity to consume remains stable or same as habits of the people regarding spending do not change owing to the constancy of the existing psychological and institutional complexities influencing consumption expenditure.
3. Psychological and Institutional Complex remains the same:
It means that there is no change in the psychological and institutional complex. Among the factors influencing the consumer, only the income will change, other institutional factors such as, desire, income behaviour, fashion, tastes and preferences, availability of goods, habits of the people, advertisement, salesmanship, tax policy population, price, etc. related to psychology do not change.
4. Capitalist Economy based on Laissez- faire:
The psychological law applies to free and prosperous capitalists economies and does not hold well in socialist and under-developed economies.
This is because, in a free economy, the people can consume any kind of goods they want, according to their necessities and desires and also there is no interference of the government in the economic affairs.
Implications of the Psychological law of consumption
1. Importance of the investment function
A vital point in this law is the tendency of people to spend less than the full amount of the increase in income. This creates a gap between aggregate income and aggregate consumption expenditure.
Since consumption is a stable function of income in the short run, the gap will widen with increase in income and lead to increase in unemployment.
If investment is increased to fill this gap then unemployment decreases. According to Lord Keynes, it is the inadequacy of investment which accounts for unemployment.
Therefore to increase employment and income one has to tackle the investment function which is the second component of effective demand.
2. This law also provides an explanation of the “turning points” of a business cycle.
This law also provides an explanation of the “turning points” of a business cycle.
The upper turning point from a boom is caused by a collapse of the marginal efficiency of capital because consumption does not keep pace with an increase in income during the phase of prosperity.
Similarly the law explains the revival of the marginal efficiency of capital and the lower turning point or recovery from a depression, on the basis of the fact that when income is reduced, consumption expenditure does not decrease in the same proportion.