Keynes’s Psychological Law of Consumption
Keynes propounded the fundamental Psychological Law of Consumption which forms the basis of the consumption function. He wrote, “The fundamental psychological law upon which we are entitled to depend with great confidence both a prior from our knowledge of human nature and from the detailed facts of experience, is that men are disposed as a rule and on the average to increase their consumption as their income increases but not by as much as the increase in their income.” The law implies that there is a tendency on the part of the people to spend on consumption less than the full increment of income.
Propositions of the Law
This law has three related propositions:
(1) When income increases, consumption expenditure also increases but by a smaller amount. The reason is that as income increases, our wants are satisfied side by side, so that the need to spend more on consumer goods diminishes. It does not mean that the consumption expenditure falls with the increase in income. In fact, the consumption expenditure increases with increase in income but less than proportionately
(2) The increased income will be divided in some proportion between consumption expenditure and saving. This follows from the above proposition because when the whole of increased income is not spent on consumption, the remaining is saved. In this way, consumption and saving move together.
(3) Increase in income always leads to an increase in both consumption and saving. This means that increased income is unlikely to lead either to fall in consumption or saving than before. This is based on the above propositions because as income increases consumption also increases but by a smaller amount than before which leads to an increase in saving. Thus with increased income both consumption and saving increase.
Proposition (1):
Income increases by R$ 60 crores and the increase in consumption is by Rs 50 crores. The consumption expenditure is, however, increasing with increase in income, i.e., Rs 170, 220, 270 and 320 crores against Rs 180, 240, 300 and 360 crores respectively.
Proposition (2):
The increased income of Rs 60 crores in each case is divided in some proportion between consumption and saving (i.e., Rs 50 crores and Rs 10 crores).
Proposition (3):
As income increases from Rs 120 to 180, 240, 300 and 360 crores, consumption also increases from Rs 120 to 170, 220, 270, 320 crores, along with in-crease in saving from Rs 0 to 10, 20, 30 and 40 crores respectively. With increase in income neither consumption nor saving has fallen.
income is measured horizontally and consumption and saving are measured on the vertical axis. C is the consumption function curve and 45° line represents income.
Proposition (1):
When income increases from OY, to OY, consumption also increases from BY to C,Y, but the increase in consumption is less than the increase in income, i.e.. C,K,<A,Y, (OY) by A,C,
Proposition (2):
When income increases to OY, and OY, it is divided in some proportion between consumption C,T, and CY, and saving A C, and A,C, respectively.
Proposition (3):
Increases in income to OY, and OY, lead to increased consumption CY>CY, and increased saving A CAC, than before. It is clear from the widening area below the C curve and the saving gap between 45⁰ line and C curve.
It’s Assumptions:
Keynes’s Law is based on the following assumptions:
1. It assumes a Constant Psychological and Institutional Complex : This law is based on the assumption that the psychological and institutional complexes influencing consumption expenditure remain constant. Such complexes are income distribution, tastes, habits, social customs, price movements, population growth, etc. In the short run, they do not change and consumption depends on income alone. The constancy of these complexes is the fundamental cause of the stable consumption function.
2. It assumes the Existence of Normal Conditions: The law holds good under normal conditions. If, however, the economy is faced with abnormal and extraordinary circumstances like war, revolution or hyperinflation, the law will not operate. People may spend the whole of increased income on consumption.
3. It assumes the Existence of a Laissez-faire Capitalist Economy: The law opera in a rich capitalist economy where there is no government intervention. People should be free to spend increased income. In the case of regulation of private enterprise and consumption expenditures by the state, the law breaks down. Thus the law is inoperative in socialist or state controlled and regulated economies.
Professor Kurihara opines that “Keynes’s law based on these assumptions may be regarded as a rough approximation to the actual macro behaviour of free consumers in the normal short period.”
4. Implications of Keynes’s Law (Or Importance of the Consumption Function): Keynes’s psychological law has important implications which in fact point towards the importance of the consumption function because the latter is based on the former. The following are its implications:
1. Invalidates Say’s Law: Say’s Law states that supply creates its own demand. Therefore, there cannot be general overproduction or general unemployment. Keynes’s psychological law invalidates Say’s Law because as income increases, consumption also increases but by a smaller amount. In other words, all that is produced (income) is not taken off the market (spent), as income increases. Thus supply fails to create its own demand. Rather it exceeds demand and leads to general overproduction and glut of commodities in the market. As a result, producers stop production and there is mass unemployment.
2. Need for State Intervention : As a corollary to the above, the psychological law highlights the need for state intervention. Say’s Law is based on the existence of laissez-faire policy and its refutation implies that the economic system is not self-adjusting. So when consumption does not increase by the full increment of income and consequently there is general overproduction and mass unemployment, the necessity of state intervention arises in the economy to avert general overproduction and unemployment through public policy.
3. Crucial Importance of Investment: Keynes’s psychological law stresses the vital point that people fail to spend on consumption the full increment of income. This tendency creates a gap between income and consumption which can only be filled by either increased investment or consumption. If either of them fails to rise, output and employment will inevitably fall.
Since the consumption function is stable in the short-run, the gap between income and consumption can only be filled by an increase in investment. Thus the psychological law emphasizes the crucial role of investment in Keynes’s theory. It is the inadequacy of investment which results in unemployment and logically, the remedy to overcome unemployment is increase in investment.
4. Existence of Underemployment Equilibrium: Keynes’s notion of underemployment equilibrium is also based on the psychological law of consumption. The point of effective demand which determines the equilibrium level of employment if not of full employment but of underemployment because consumers do not spend the full increment of their income on consumption and there remains a deficiency in aggregate demand. The full employment equilibrium level can, however, be reached if the state increases investment to match the gap between income and consumption.
5. Declining Tendency of the Marginal Efficiency of Capital: The psychological law also points towards the tendency of declining marginal efficiency of capital in a laissez-faire economy. When income increases and consumption does not increase to the same extent, there is a fall in demand for consumer goods.
This results in glut of commodities in the market. The producers will reduce production which will, in turn, bring a decline in the demand for capital goods and hence in the expected rate of profit and business expectations. It implies a decline in the marginal efficiency of capital.
It is not possible to arrest this process of declining tendency of marginal efficiency of capital unless the propensity to consume rises. But such a possibility can exist only in the long run when the psychological law of consumption does not hold good.
6. Danger of Permanent Over-saving or Under-investment Gap : Keynes’s psychological law points out that there is always a danger of an over-saving or under-investment gap appearing in the capitalist economy because as people become rich the gap between income and consumption widens.
This long-run tendency of increase is saving and fall in investment is characterized as secular stagnation. When people are rich, their propensity to consume is low and they save more. This implies low demand which leads to decline in investment. Thus the tendency is for secular stagnation in the economy.
7. Unique Nature of Income Propagation: The fact that the entire increased income is not spent on consumption explains the multiplier theory. The multiplier theory or the process of income propagation tells that when an initial injection of investment is made in the economy, it leads to smaller successive increments of income.
This is due to the fact that people do not spend their full increment of income on consumption. In fact, the value of multiplier is derived from the marginal propensity to consume, i.e., Multiplier 1-1/MPC. The higher the MPC, the higher the value of the multiplier, and vice versa.
8. Explanation of the Turning Points of the Business Cycles: This law explains the points of a business cycle. Before the economy reaches the full employment level, the downturn starts because people fail to spend the fu increment of their income on consumption. This leads to fall in demand, overproduction, unemployment and decline in the marginal efficiency of capital. Figure 4 panel (A) shows this downturn movement. When income increases above the breakeven point by Y’Y”, consumption expenditure increases by a smaller amount C’C”, (C’C” <Y’Y”). Before that economy reaches the full-employment income level Y,, the downturn will start because the gap between 45° line and C curve continues to widen.
Conversely, the upturn in the economy starts before it reaches the stage of complete depression because when income falls, consumption also falls but by less than the fall in income. People continue to buy consumer goods even when their income falls. So when the excess stock of commodities is exhausted in the community during a expression, the existence of consumer expenditure on goods leads to revival.
This is best explained with help of Figure 4 Panel (B) where below the breakeven point B, the C curve is above the 45° income line. The fact that the consumption function curve C is above the income line shows that revival will start before income falls to zero. This is because the fall in consumption C’C” is less than the fall in income Y’Y.
