Tuesday, April 5, 2011

Consumption and Savings

Goods are of two kinds:

1. Consumption goods: These are goods, which people require for their day-to-day living. These goods get used up, or get consumed and hence the name. Example: toothpaste, exercise book, soap, television, mobile phone etc.

2. Capital goods: Capital goods are those goods, which help to produce consumption goods, or other capital goods. Example: machine that makes the toothbrush, or a machine that make the parts of another machine.

In 1931 Mr. R.F. Kahn noticed that one employment increases the total employment in the economy. For example, if there is employment in the construction of roads and bridges, this will increase the income of those who are employed in the construction works. As a result of this, demand for consumption goods will increase. When more consumption goods are demanded, it increases the price of consumption goods, assuming that supply remains constant. Consequently, when more consumption goods are sold, it increases the profit of the sellers. When profit increases, a part of it is reinvested to produce more consumption goods, as it is bringing in more profit.

Fresh investment creates more employment opportunities in the consumption goods industries. Again, for the production of more consumption goods, more capital goods, like machinery, will be required. So the production of capital goods will also increase. This will increase the employment in the capital goods industries.

Thus one employment in the construction works industry will increase the total employment in the economy.

Gross National Product is a measure of the performance of the economy of a country. It is called the yardstick of an economy's progress. A more reliable indicator is per capita income, which is national income per head. National income is said to be in equilibrium when it is exactly equal to expenditure.

National income is denoted by Y. It has two components, consumption(C) and savings(S). A part of the income is spent on consumption. That which is not spent is obviously saved. It may or may not be invested.

So we can say that Y = C + S

C is the supply of consumption goods and S is the supply of savings. This is the supply side of the picture.

National income is basically the money value of all goods and services produced in an economy during an accounting year. Total goods produced or total production is the sum total of consumption goods and capital goods. The total expenditure of the community is denoted by E. It means aggregate expenditure or effective demand. Aggregate expenditure is called effective demand because whatever is spent must be backed up by an equivalent demand.

So we can also say that E = C + I

C is the demand for consumption goods, or expenditure made by the household sector.
I is the demand for investment made by the private firms.
This is the Demand side of the picture.

National Income is said to be in equilibrium when the country spends as much as it earns, or when income is equal to expenditure. That means when the supply side Y = the demand side E.

Y = E
Or, C + S = C + I

C cancels out from both the sides of the equation, leaving S and I on either side, which are equal.

That is, S = I. So the major point is that Savings (S) is equal to investment (I), only when the national income is equal to national expenditure. Gross national income is the money value of gross national products.

Consumption: Consumption is basically the part of the income that is spent. It depends upon the disposable income (Yd). Disposable income means money income minus taxes paid.

So, Yd = Y - T

Y is the money income and T is the tax paid.

Therefore, consumption (C) is a function of disposable income (Yd).

C = f(Yd)

Consumption function: Propensity to consume: We know that Y = C + S. Delta (Δ) is the symbol used to denote change. If income increases byΔY, and consumption by ΔC, and savings by ΔS, then ΔY = ΔC + ΔS. Change in consumption due to change in income is called the consumption function. In 1936 Prof. J. M. Keynes stated in his book “The general Theory of Income, Interest and Money” that if income increases, consumption will alsoincrease, but not proportionately. For example, if the income of an individual increases by $100, consumption mayincrease by $80, and savings by $20. Here ΔY = $100, ΔC = $80 and ΔS = $20.

Marginal propensity to consume: Change in consumption induced by change in income is called Marginal Propensity to Consume.

We know that ΔY = ΔC + ΔS
Dividing both sides by ΔY,
we get ΔY/ ΔY = ΔC/ΔY + ΔS/ΔY
Or, 1 = ΔC/ΔY + ΔS/ΔY
Or, 1 = 80/100 + 20/100
Or, 4/5 + 1/5 = 1
Or, b + s = 1
“b” is the Marginal Propensity to Consume, and “s” is the Marginal Propensity to save.The sum of Marginal Propensity to Consume (b) and Marginal Propensity to save (s) is always equal to 1.

“b” can thus be defined as the ratio of change in aggregate consumption brought about by a change in national income. In a like manner we can define “s” as the ratio of change in savings to change in income, that brought it about.

According to Mr. Keynes as income increases, consumption also increases. Therefore “b” is always greater than 0 (b>0). But “b” always increases less than proportionately (b<1). Similarly “s” is always greater than 0 (s>0) but less than 1 (S<1).
Since b + s = 1, s = 1 – b. Savings is residual in nature.

“s” is the Marginal Propensity to Save.

Also read: Consumption Function and Savings Function

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