Important Theories of Consumptions. Economics

                           * Theories of Consumption*

Introduction to Theories of Consumption:

Consumption, the act of using goods and services to satisfy human needs and desires, lies at the core of economic activity. Why individuals make the spending choices they do has been a subject of deep investigation and analysis by economists and researchers. Various theories of consumption attempt to shed light on the factors that influence these decisions. By delving into these theories, we gain insights into the intricate web of economic, psychological, and societal forces that shape how individuals allocate their resources.

In this exploration of the theories of consumption, we will uncover a diverse array of perspectives that range from classic economic models to those infused with behavioral insights. These theories not only help us understand how consumption patterns emerge but also offer valuable implications for economic policy, business strategies, and the broader understanding of human behavior.

As we embark on this journey, we will delve into the classical view that links consumption with current income and examine the groundbreaking insights of Keynesian theory, which emphasizes the interplay between present and future income expectations. We'll explore theories that consider the entire lifecycle of an individual, investigating how consumption evolves from youth to retirement. Additionally, we'll delve into the realm of behavioral economics, where psychological nuances reshape our understanding of consumption decisions.

From the concept of permanent income to the impact of social comparisons and the anticipation of future taxes, each theory presents a unique lens through which we can decipher the intricate choices individuals make in their pursuit of happiness, comfort, and prosperity. Through this exploration, we will unravel the complex tapestry that weaves economics, psychology, and society into the fascinating phenomenon of consumption behavior.

1 - The Classical Theory of Consumption:

The Classical Theory of Consumption is one of the foundational concepts in economics that seeks to explain how individuals allocate their income between spending on goods and services and saving. This theory, rooted in the works of classical economists like David Ricardo and John Stuart Mill, provides insights into how changes in income influence consumption decisions.

Basic Assumptions:

Income Determination: The theory assumes that an individual's consumption is primarily determined by their current income.
Savings: Savings are considered the residual of income after consumption. In other words, any income not spent on consumption is automatically saved.

Key Principles:

Propensity to Consume: The propensity to consume is the fraction of additional income that an individual chooses to spend on consumption. It's represented by the consumption function, which indicates how changes in income affect consumption.

Marginal Propensity to Consume (MPC): The MPC is the change in consumption resulting from a one-unit change in income. In the classical view, the MPC is assumed to be less than 1, indicating that not all additional income is spent.
Marginal Propensity to Save (MPS): This is the fraction of additional income that an individual saves. Since savings are the residual of income after consumption, MPS = 1 - MPC

2 -Relative Income Theory of Consumption:

The Relative Income Theory of Consumption is an insightful concept that offers an alternative perspective to understanding consumption behavior. This theory departs from traditional economic models by emphasizing the importance of an individual's income relative to the income of others in influencing their consumption decisions. Proposed as a reaction to the shortcomings of the classical theories, the relative income theory introduces social and comparative elements into the realm of consumption analysis.

Key Principles:

Social Comparisons: According to this theory, individuals do not base their consumption solely on their own income level. Instead, they engage in social comparisons by assessing how their income compares to the income of others within their reference group.

Consumption as a Status Symbol: People often use their consumption choices to signal their social status and to position themselves in relation to others. High consumption may be driven by the desire to maintain or enhance one's social standing.

Veblen Effect: Named after economist Thorstein Veblen, this effect describes how individuals may increase their consumption of certain goods solely because they are considered luxurious or prestigious. This is driven by the desire to demonstrate higher social status.

3 - Life Cycle Theory of Consumption:

The Life Cycle Theory of Consumption is a comprehensive economic concept that seeks to explain how individuals manage their consumption and savings over the various stages of their lives. Developed by economists Franco Modigliani and Albert Ando in the 1950s, this theory provides insights into how people plan their spending patterns to maintain a stable standard of living from youth to retirement.

Key Principles:

Consumption Smoothing: The central idea of the life cycle theory is "consumption smoothing." Individuals aim to maintain a relatively stable level of consumption throughout their lifetime, regardless of fluctuations in income.

Borrowing and Saving: People are willing to borrow when they are young and have lower income to fund their education, housing, and other essential needs. As they enter their working years and earn higher income, they repay those loans and save for future needs.

Dis-Saving in Retirement: During retirement, individuals start drawing from their savings to support their consumption since their earning potential has diminished.

4. Permanent Income Theory of Consumption:

Permanent income theory of consumers’ behaviour has been put forward by a well-known American economist, Milton Friedman. Though Friedman’s permanent income hypothesis differs from life cycle consumption theory in details, it has important common features with the latter. Like the life cycle approach, according to Friedman, consumption is determined by long-term expected income rather than current level of income.

It is this long-term expected income which is called by Friedman as permanent income on the basis of which people make their consumption plans. To make his point clear, Friedman gives an example which is worth quoting. According to Friedman, an individual who is paid or receives income only once a week, say on Friday, he would not concentrate his consumption on one day with zero consumption on all other days of the week.

He argues that an individual would prefer a smooth consumption flow per day rather than plenty of consumption today and little con­sumption tomorrow. Thus consumption in one day is not determined by income received on that particular day. Instead, it is determined by average daily income received for a period. This is on the line of life cycle hypothesis. Thus, according to him, people plan their consumption on the basis of expected average income over a long period which Friedman calls permanent income.

It may be noted that permanent income or expected long-term average income is earned from both “human and non-human wealth”. The income earned from human wealth which is also called human capital refers to the return on income derived from selling household’s labour services, that is, efforts and abilities of its labour.

This is generally referred to as labour income. Non-human wealth consists of tangible assets such as saved money, debentures, equity shares, real estate and consumer durables. It is worth noting that Friedman regards consumer durables such as cars, refrigerators, air conditioners, television sets as part of households’ non-human wealth. The imputed value of the flow of services from these consumer durables is considered as consumption by Friedman.

Relationship between Consumption and Permanent Income:

Now, what is the precise relationship between consumption and permanent income (that is, the expected long period average income). According to permanent income hypothesis, Friedman thinks that consumption is proportional to permanent income

CP=kYP

where

YP is the permanent income

CP is the permanent consumption

k is the proportion of permanent income that is consumed.

The proportion or fraction k of permanent income that is consumed depends upon the following factors:

i. Rate of interest (i):

At a higher rate of interest the people would tend to save more and their consumption expenditure will decrease. The lowering of rate of interest will have opposite effect on the consumption.

ii. The proportion of non-human wealth to human wealth:

The relative amounts of income from physical assets (i.e., non-human wealth) and income from labour (i.e., human wealth) also affects consumption expenditure. This is denoted by the term w in the permanent consumption func­tion and is measured by the ratio of non-human wealth to income. In his permanent income hypoth­esis Friedman suggests that consumption expenditure depends a good deal on the wealth or assets possessed by the people. The greater the amount of wealth or assets held by an individual, the greater would be its propensity to consume and vice-versa.

iii. Desire to add to one’s wealth:

Lastly, households’ preference for immediate consumption as against the desire to add to the stock of wealth or assets also determines the proportion of permanent income to be devoted to consumption. The desire to add to one’s wealth rather than to fulfill one’s wants of immediate consumption is denoted by u.

Thus rewriting the consumption function based on Friedman’s permanent income hypothesis we have

CP =k (i, w, u) YP

The above function implies that permanent consumption is function of permanent income. The proportion of permanent income devoted to consumption depends on the rate of interest (i), the ratio of non-human wealth to labour income (w) and desire to add to the stock of assets (u).

5-The Keynesian Theory of Consumption

The Keynesian Theory of Consumption, formulated by British economist John Maynard Keynes, is a significant departure from classical economic theories that solely emphasized the role of current income in determining consumption patterns. Keynes introduced a more nuanced perspective that considers both current income and future income expectations as critical factors influencing individuals' spending behavior. This theory holds particular relevance in understanding how consumption decisions impact overall economic activity, especially during periods of economic instability.

Key Principles:

Propensity to Consume (MPC): A central concept in the Keynesian theory of consumption is the "marginal propensity to consume" (MPC). It represents the fraction of additional income that individuals choose to spend on consumption. Unlike classical theories, which assumed an MPC close to 1 (i.e., individuals spend nearly all additional income), Keynes acknowledged that the MPC could be less than 1. This recognizes that people might save part of their income even when it increases.

Importance of Expectations: Keynes emphasized that people don't base their consumption decisions solely on their current income. Instead, they consider their expectations of future income. If individuals anticipate higher future income, they might increase their consumption, even with a current income boost.

Income and Consumption Relationship: Keynesian consumption is not strictly tied to current income levels. Autonomous consumption, which is the consumption that occurs even when income is zero, suggests that people spend to some extent even if they have no income. This concept counters the classical idea that consumption starts only when income is earned.

Multiplier Effect: The theory introduces the multiplier effect, a concept central to Keynesian economics. When there's an initial increase in spending (due to government intervention or other factors), it triggers a chain reaction. This increase in demand leads to increased production and employment, creating a larger overall economic impact than the initial spending increase itself.