Consumption is the purchase of final goods and services by individuals. A major component of GDP for most economies, consumption is studied extensively by economists. In the United States, consumption makes up about two-thirds of GDP every year.
An individual's level of consumption is often modeled using a simple formula, called the Keynesian consumption function or simply the consumption function. As you will see, the consumption function describes three traits that Keynes attributed to consumer consumption behavior: autonomous consumption, marginal propensity to consume, and average propensity to consume.
The Keynesian Consumption Function
Before we go over the actual structure of the function, we need to learn a little bit more about exactly what this equation is meant to model.
The first characteristic is autonomous consumption. Autonomous consumption is simply the consumption that an individual must engage in, regardless of income. The quintessential example of this is that, no matter how rich or poor an individual is, they still need to eat. Because it is not related to the level of income, autonomous consumption is a fixed amount.
The second characteristic is the marginal propensity to consume. Often abbreviated to MPC, the marginal propensity to consume measures the percentage of an individuals disposable income, or income after taxes, that they use in consumption. Measured as a decimal, if a consumer has an MPC of 0.8, or 80%, they will use $0.80 of every dollar of their disposable income on consumption. With (Y-T) representing disposable income, the amount of consumption an individual engages in can be shown as MPC/(Y-T).
This idea is tied closely to the idea of a marginal propensity to save (MPS). MPS represents the percentage of every dollar of disposable income that is kept as savings. Since all disposable income must be either spent or save, MPC+MPS=1. With both MPC and MPS being decimal representations of percentages, this simply shows that 100% of disposable income is either spent or saved.
This simple tautology allows us to determine the MPS from the MPC, though. Rearranging the formula, MPS=1-MPC. So, the amount that each individual saves can be written as either MPS/(Y-T) or (1-MPC)/(Y-T). In the same vein, the amount of consumption for each individual, MPC/(Y-T), can also be written as (1-MPS)/(Y-T).
The last characteristic is that the average propensity to consume, the overall percentage of income that is spent on consumption, declines as incomes rises. This is a necessary corollary to the combination of autonomous consumption and marginal propensity to consume. As income increases, a lower percentage of income must be spent on autonomous consumption. Since the marginal propensity to consume doesn't increase, this causes overall consumption spending as a percentage of income to decrease as income increases. Keynes believed that saving was a luxury, and so the percentage of income saved would increase as income increased.
C =A + c(Y-T)
Finally, we are ready to fit all of this into the Keynesian consumption function. While this function doesn't fit exactly the empirical data that has been collected over the years, it is a very good approximation for early Economics students.
A: Represents autonomous consumption. As described earlier, this is a fixed quantity that decreases in importance as income grows.
c: Represents the MPC. Because of this, c is also fixed as long as the MPC remains constant, and is less than one; often written 0≤c<1.
Y: Represents income. This is, perhaps usurprisingly, the monetary value of payment for goods sold and services provided.
T: Represents taxes. This is the monetary value an individual must pay to the government. Because T is generally a function of income, you may see this written as T(Y) in more complex formulas.
(Y-T): Putting income and taxes together, we get the actual income that an individual has available to themselves, called disposable income. This is the value that c, the MPC, is multiplied by to find discretionary consumption.
As you can see, this function has all of the characteristics believed by Keynes to be central to consumption behavior. The average propensity to consume decreases as Y increases, there is autonomous consumption, and their is a marginal propensity to consume relative to disposable income.