Theories of consumption


Date Posted: 8/20/2018 11:08:59 AM

Posted By: Faimus  Membership Level: Silver  Total Points: 892

Consumption expenditure is one of the key sectors of any country's economy. This expenditure is determined by a number of factors such as wealth, availability of consumer credit, consumer expectations about the future, consumer tastes and preferences, capital gains among others. However, income is arguably considered the main determinant of consumption. Scholars have advanced a number of theories to explain consumption behaviour by individuals in any given economy. Four of these theories have been explained in detail below.

The first theory is the absolute income hypothesis. This theory was postulated by Keynes. According to this hypothesis, consumption depends on the current level of disposable income. Disposable income refers to the total amount of income available for use by households or the after tax personal income. This theory also argues that consumption is directly but not proportionately related to the current level of aggregate disposable income. This therefore implies that the average propensity to consume (APC) declines with increase in income. Average propensity to consume is described as the proportion of income that goes to consumption. This assumption, the unproportionate change in consumption, is based on the argument that the consumer's reaction to change is not instant but gradual. This is because the change in income may not be permanent. It can therefore be concluded that consumption over time does not only depend on income over time but also the previous level of consumption.

The relative income hypothesis was put forth by James Duesenberry in 1949. This theory revolves around two assumptions. These assumptions are; the consumption behaviour of individuals is interdependent and consumer relations are irreversible overtime. In the first assumption, that is the consumption behaviour of individuals is interdependent, this theory argues that, the ratio of income consumed depends on an individual's absolute income as well as their absolute income. Relative

income refers to an individual's percentile position in the total income distribution within a community. If in a given year, an increase in the income of an individual is accompanied by improvement in their percentile position, then the individual will consume a small percentage of their income. On the other hand, if the percentile position of the same individual remains the same over time then, the individual the same percentage of their income regardless of the changes in the absolute income. The assumption that consumption relations are irreversible over time makes this theory to be referred to as the previous peak theory. According to this assumption, when income falls during the cyclical downswing, the resultant fall in consumption is less than proportionate. This is the case because individuals tend to base their consumption patterns on the previous levels of consumption. When income increases, consumption increases proportionately. However when income falls below the previous peak, consumption does not fall proportionately. This results in what is referred to as the ratchet effect.

Another theory is the permanent income hypothesis which was put forward by Friedman in 1957. According to this theory, consumption depends on permanent income. Permanent income is defined as the present value of expected flow of long term income. It further argues that permanent consumption is proportional to permanent income. It also suggests that the ratio of permanent consumption to induced consumption is constant at all levels of income. Measured income is considered to be made of two components; permanent income and transitory income. Transitory income is the temporary unexpected rise or fall in income. It is the difference between the measured income and permanent income. Transitory income may be positive, negative or zero and thus the sum of the transitory income for a group of people is equal to zero. Like measured income, likewise measured consumption is the composition of two components; measured consumption and transitory consumption. Measured consumption is the planned level of spending while transitory consumption is the unplanned or temporary increase or decrease in the level of consumption. Permanent consumption is a function of permanent income while transitory consumption is a function of transitory income. The sum of transitory consumption for a group of people just like transitory income is equal to zero.

The final theory is the life cycle income hypothesis. This theory was advanced by Modiglani, Ando and Brumberg. It is therefore also referred to as the MBA hypothesis. This theory argues that consumption depends on the expected stream of disposable income over a long period of time and the present value of wealth. It also suggests that individuals tend to spread out the present value of all future income streams on consumption through out their lifetime. It can be thus concluded that consumption is a function of lifetime income. During the early years of any individual's life they are net borrowers meaning that their consumption exceeds their income. They borrow to consume and build on human capital. During the middle years, they are net savers, their income exceeds their consumption. At this stage, they are paying loans and saving for future consumption, investment and bequests. In the late years of the individual's life, they are net dissavers, that is their consumption exceeds income. They consume out of savings, pension and social security funds. This implies that the average propensity to consume is high in the early and late years of an individual's life. This thus causes non proportionality in the income and consumption relationship in the short run. However in the long run, consumption is proportional to income.

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