Introduction
The concepts of Consumption Function and Investment Function are among the most important topics in Macroeconomics, especially in the Keynesian Theory of Income and Employment. These concepts explain how individuals spend their income and how businesses decide to invest in the economy.
According to the British economist John Maynard Keynes, the level of national income, output, and employment in an economy depends largely on Aggregate Demand (AD). Consumption and Investment are the two most important components of Aggregate Demand.
PART I: CONSUMPTION FUNCTION
Meaning of Consumption
Definition
Consumption refers to the expenditure made by households on goods and services for the satisfaction of wants.
In simple words:
Consumption means spending money to buy goods and services for personal use.
Examples
- Buying food
- Paying rent
- Purchasing clothes
- Paying electricity bills
- Spending on education and healthcare
What is Consumption Function?
Definition
The Consumption Function shows the relationship between consumption expenditure and income.
It explains:
How much people spend and how much they save at different levels of income.
Keynes observed that when income increases, consumption also increases, but not by the same proportion.
Consumption Function Equation
The consumption function is represented as:
Where:
- C = Consumption expenditure
- a = Autonomous Consumption
- b = Marginal Propensity to Consume (MPC)
- Y = Income
Important Terms in Consumption Function
1. Income (Y)
Definition
Income refers to the earnings received by households from various sources.
Examples:
- Salary
- Wages
- Interest
- Rent
- Profit
Income is the main determinant of consumption.
2. Consumption Expenditure (C)
Definition
Consumption expenditure refers to the amount spent by households on goods and services.
Example:
If a person earns ₹50,000 and spends ₹40,000, then:
Consumption = ₹40,000
3. Saving (S)
Definition
Saving is the part of income that is not consumed.
Formula:
Where:
- S = Saving
- Y = Income
- C = Consumption
Example
Income = ₹50,000
Consumption = ₹40,000
Saving = ₹10,000
4. Autonomous Consumption (a)
Definition
Autonomous consumption is the minimum consumption expenditure that occurs even when income is zero.
People still need food, shelter, and basic necessities.
They may borrow money or use past savings.
Example
Even if a person’s income is ₹0, they may spend ₹5,000 on basic needs.
This ₹5,000 is autonomous consumption.
5. Induced Consumption
Definition
Consumption that changes with income is called induced consumption.
As income rises, spending also rises.
Example
Income increases from ₹20,000 to ₹30,000.
Consumption increases from ₹18,000 to ₹24,000.
The additional ₹6,000 is induced consumption.
Keynes’ Psychological Law of Consumption
One of Keynes’ most important ideas is the Psychological Law of Consumption.
Statement
“Men are disposed, as a rule, and on average, to increase their consumption as their income increases, but not by as much as the increase in income.”
Meaning
When income rises:
- Consumption rises.
- Savings also rise.
- Consumption rises less than income.
Example
| Income (₹) | Consumption (₹) |
|---|---|
| 10,000 | 9,500 |
| 20,000 | 18,000 |
| 30,000 | 25,000 |
As income increases by ₹10,000, consumption increases but by less than ₹10,000.
Average Propensity to Consume (APC)
Definition
APC measures the proportion of income spent on consumption.
Formula:
Where:
- C = Consumption
- Y = Income
Example
Income = ₹40,000
Consumption = ₹32,000
Thus, 80% of income is spent on consumption.
Marginal Propensity to Consume (MPC)
Definition
MPC measures the change in consumption resulting from a change in income.
Formula:
Where:
- ΔC = Change in Consumption
- ΔY = Change in Income
Example
Income rises from ₹50,000 to ₹60,000.
Consumption rises from ₹40,000 to ₹48,000.
Meaning:
For every additional ₹1 earned, ₹0.80 is spent.
Factors Affecting Consumption Function
Objective Factors
These are external factors.
1. Income Level
Higher income increases consumption.
2. Wealth
More wealth leads to higher spending.
3. Interest Rate
Higher interest rates encourage saving.
4. Taxation
Higher taxes reduce disposable income.
5. Price Level
Higher prices reduce purchasing power.
Subjective Factors
These are psychological motives.
Examples:
- Desire to save
- Future security
- Family responsibilities
- Business motives
PART II: INVESTMENT FUNCTION
Meaning of Investment
Definition
Investment refers to expenditure on the creation of capital assets.
In simple words:
Investment means spending money to increase future production capacity.
Examples
- Building factories
- Purchasing machinery
- Constructing roads
- Building warehouses
- Installing new technology
Investment Function
Definition
The Investment Function shows the relationship between investment and factors influencing investment decisions.
According to Keynes:
Investment depends mainly on the expected profitability of investment and the rate of interest.
Types of Investment
1. Autonomous Investment
Definition
Investment that does not depend on income.
Examples:
- Government infrastructure projects
- Defence expenditure
- Public sector investment
Even if national income changes, such investments continue.
2. Induced Investment
Definition
Investment that depends on income and demand.
When income rises:
- Demand rises.
- Production rises.
- Investment rises.
Determinants of Investment
1. Rate of Interest
Definition
Interest is the cost of borrowing money.
Relationship:
- Higher interest rate → Lower investment.
- Lower interest rate → Higher investment.
Reason
Borrowing becomes cheaper when interest rates are low.
2. Expected Profitability
Definition
Expected profitability refers to the anticipated earnings from an investment project.
Firms invest only if they expect future profits.
Marginal Efficiency of Capital (MEC)
This is one of the most important UGC NET concepts.
Definition
Marginal Efficiency of Capital refers to the expected rate of return from an additional unit of capital.
Keynes defined MEC as:
The rate of discount that equates the present value of expected returns with the supply price of capital.
Simple Meaning
MEC tells us:
How profitable a new investment is expected to be.
Example
A machine costs ₹1,00,000.
Expected annual returns = ₹15,000.
If profitability is high, firms will invest.
Relationship Between MEC and Interest Rate
Investment occurs when:
Example
MEC = 12%
Interest Rate = 8%
Since:
12% > 8%
Investment will take place.
Example 2
MEC = 5%
Interest Rate = 8%
Since:
5% < 8%
Investment will not occur.
Average Propensity to Save (APS)
Definition
APS measures the proportion of income saved.
Formula:
Where:
- S = Saving
- Y = Income
Marginal Propensity to Save (MPS)
Definition
MPS measures the proportion of additional income saved.
Formula:
Relationship Between MPC and MPS
Since income is either consumed or saved:
This is an important UGC NET formula.
Importance of Consumption and Investment Functions
1. Determination of National Income
Both consumption and investment determine aggregate demand.
2. Employment Generation
Higher investment creates jobs.
3. Economic Growth
Investment increases productive capacity.
4. Business Cycle Analysis
Fluctuations in investment are a major cause of economic booms and recessions.
UGC NET Important One-Liners
Consumption Function
Relationship between consumption and income.
Autonomous Consumption
Consumption even at zero income.
APC
Consumption divided by income.
MPC
Change in consumption divided by change in income.
Saving
Income minus consumption.
Investment
Addition to capital stock.
Autonomous Investment
Investment independent of income.
Induced Investment
Investment dependent on income.
MEC
Expected profitability of capital.
Keynes’ Psychological Law
Consumption increases with income, but less than proportionately.
Key Formulae