Key Benefits of Keynesian Consumption Function

Here we detail about the four key benefits of Keynesian consumption function in economics.

(1) The concept of consumption function helps us to invalidate Say’s law of classical economics:

In fact, Keynes relied on his consumption function for proving the invalidity of Say’s law.

According to Say’s law, every supply creates its own demand and therefore there is no problem of deficiency of aggregate demand. Therefore, general overproduction and unemployment in the economy is not possible because adequate amount of aggregate demand is ever present.

Now, according to the Keynesian consumption function, when income increases consumption increases less than the increase in income and therefore saving gap emerges between income and consumption. This saving gap implies that all output produced may not be sold and the problem of deficiency of demand will arise unless this saving gap is matched by an equal amount of investment demand.

There is no guarantee that the saving done will be automatically invested or, in other words, it is not necessary that investment demand will be equal to the saving gap. Thus, the contention of the Say’s law that every supply creates its equal demand is not valid. No doubt, every supply or production creates income equal to the output produced.

But since all income is not consumed and there is no guarantee that investment will be equal to the saving so emerged. Say’s law is proved invalid. When investment is less than the saving gap corresponding to full-employment level of income, the aggregate demand is not sufficient to provide full-employment to the people and other resources. Thus, the problem of deficiency of effective demand and hence general unemployment and overproduction arises in a free enterprise capitalist economy.

(2) The concept of propensity to consume is also important because it brings out crucial significance of investment demand for determination of the level of income and employment in a capitalist economy. From the concept of propensity to consume we know that consumption increases less than the increase in income and as a result gap emerges between income and consumption.

To maintain a certain given level of income and employment, gap between income and consumption at that level must be bridged by investment expenditure otherwise it will not be possible to maintain that level of income and employment because aggregate demand would not be large enough.

This indicates the crucial importance of the investment demand in the determination of income and employment. To prevent the establishment of underemployment equilibrium in the economy or, in other words, for achieving full-employment equilibrium, investment demand must be equal to the saving gap at the level of full-employment. Keynes also showed that consumption function remains stable in the short run and therefore economic fluctuations in a capitalist economy are largely due to the fluctuations in investment demand.

Thus from the concept of propensity to consume it follows that investment demand is vitally important in determining the level of income and employment. If it were possible to raise the propensity to consume in the ort run, then without raisin” ‘ vestment, we could have raised the level of income and employment. Since propensity to consume at a given level of income generally remains stable, we have to increase investment for achieving full employment in the economy.

(3) Another crucial importance of the concept of propensity to consume is that from it we derive the theory of multiplier which has great practical importance in the formulation of macro- economic policy, especially of public works in times of depression. The magnitude of multiplier is equal to the reciprocal of one minus marginal propensity to (K = 1/1- MPC) where K stands for multiplier and MPC for marginal propensity to consume.

According to this concept of multiplier, when investment increases, income, output and employment increase by a multiple amount, depending upon the size of the multiplier. Income increases manifold than the original investment because of the nature of consumption function.

When some investment in some projects is undertaken, it leads to the increase in income of those employed in the projects but the process does not stop here. The increases in income are further spent on consumption and this leads to further increase in income and so the chain of increases in income and consumption continues and the ultimate increase in income and employment is multiple of the original increment in investment.

If the marginal propensity to consume were equal to zero, then all increments in income brought about by additional investment would have been saved and therefore multiplier process would not have worked. Since the marginal propensity to consume is greater than zero, the increase in net investment has a multiplier effect on income, output and employment.

Thus, the effect of investment on income depends on the size of the multiplier which depends on the value of the marginal propensity to consume. The greater the marginal propensity to consume, the greater the size of the multiplier.

(4) From the concept of consumption function, we can also explain why there is a tendency for the marginal efficiency of capital to decline. The declining tendency of the marginal efficiency of capital is due to the nature of the consumption function. Two features of consumption function are important. First, the marginal propensity to consume is less than one which implies that as income increases, consumption increases less than this. Secondly, consumption function is stable in the short run i.e., it does not shift much in the short run.

As we know that the level of investment is a crucial factor in the determination of income and employment, fluctuations in the levels of income and employment depend primarily on the fluctuations in investment. The investment demand in the short run is determined by the rate of interest on the one hand and marginal efficiency of capital on the other.

Since the rate of interest is relatively sticky, it is the marginal efficiency of capital which greatly affects the level of investment in the short run. Marginal efficiency of capital is nothing but the expected rate of profit on investment in the future.

Thus, the marginal efficiency of capital is determined by the expectations of the entrepreneurs regarding the earning of profits from capital assets in the future. But entrepreneurs tend to base their expectations largely on existing facts expecting that the current situation will continue in the future also unless there are definite and concrete signs to the contrary.

The most important fact in the current situation which affects the entrepreneur’s expectations regarding profit prospects and thereby the marginal efficiency of capital is the level of current consumption. Thus we see that in the Keynesian scheme of things level of investment ultimately depends upon the level of current consumption.

Since marginal propensity to consume is less than one and also the consumption function is stable in the short run, when income increases, consumption does not increase proportionately. As a result, the aggregate demand becomes deficient and the marginal efficiency of capital declines.

The decline in the marginal efficiency of capital adversely affects investment which stops rising. As a result, the growth process stops and economic recession occurs. The limited possibilities of increasing investment in the mature capitalist economies are partly due to the constancy of consumption function and declining average propensity to consume which causes the marginal efficiency of capital to decline. It evident from above that consumption function plays an important role in the determination of income and employment in a free market economy.