It is the function that represents the relationship between consumption and income. It depicts a positive relationship between the two variables and helps in determining the rate of change in one variable in responses to the other. It is noted that in response to the increase in income of a consumer, his consumption also increases. Whereas, if the income of a consumer falls, his consumption will also fall. This rate of increase and decrease in consumption in response to increase or decrease in income is depicted through consumption function.
The basic formula for the consumption function is often represented as:
C = C(Y)
Where:
- C represents consumption spending.
- Y represents disposable income.
The propensity to consume
Propensity to consume shows the relationship between different levels of income and the different levels of consumption. It shows the portion of total income that is being consumed.
Average propensity to consume
It refers to the relationship between consumption and income. It shows the proportion of income that a person or household typically spends rather than saves. It can be calculated by dividing consumption by income.
Marginal propensity to consume
Marginal propensity to consume refers to the relationship between change in consumption and change in income. It shows the change in portion of income that will be spent on consumption when there is a change in income. The MPC represents the fraction of an additional dollar of income that a person or household will spend rather than save. For example, if a household’s MPC is 0.80, it means that they will spend 80 cents of every additional dollar they earn and save the remaining 20 cents.
Propensity to save
It is the ratio of savings and income that shows the share of income that is being saved.