Question

Write explanatory answer:

Explain the subjective and objective factors determining consumption function.

Answer 1

Factors Affecting Consumption Functions: Subjective and Objective Factor!

According to Keynes, two types of factors influence the consumption function: subjective and objective. The subjective factors are endogenous or internal to the economic system itself. The subjective factors relate to psychological characteristics of human nature, social structure, social institutions and social practices.

These are likely to remain more or less stable during the short period. Established behaviour pattern undergoes material change only over long periods. These factors fundamentally determine the form of the consumption function (i.e., slope and position of the propensity to consume, the С curve).

The objective factors affecting the consumption function are exogenous, or external to the economy itself. These factors may at times undergo rapid changes. Thus, objective factors may cause a shift in the consumption function.

Subjective Factors:

Subjective factors basically underlie and determine the form of the consumption function (i.e., its slope and position).

The subjective factors concerned are:

(1) behaviour patterns fixed by the psychology of human nature

(2) the institutional arrangements of the modern social order, and social practices relating to the behaviour patterns of business firms with respect to wage and dividend payments and retained earnings, and the institution controlling the distribution of income.

Human behaviour regarding consumption and savings out of increased income depends on psychological motives.

First, there are motives which “lead individuals to refrain from spending out of their incomes.”

Keynes enlists eight such motives:

1. The Motive of Precaution:

The desire to build up a reserve against unforeseen contingencies.

2. The Motive of Foresight:

The desire to provide for anticipated future needs, e.g., in relation to old age, family education, etc.

3. The Motive of Calculation:

The desire to enjoy interest and appreciation, because a larger real consumption, at a later date, is preferred to a smaller immediate consumption.

4. The Motive of Improvement:

The desire to enjoy a gradually increasing expenditure since it gratifies the common instinct to look forward to a gradually improving standard of life rather than otherwise.

5. The Motive of Independence:

The desire to enjoy a sense of independence and the power to do things.

6. The Motive of Enterprise:

The desire to secure a mass de manoeuvre to carry on speculation or establish business projects.

7. The Motive of Pride:

The desire to possess or to bequeath a fortune.

8. The Motive of Avarice:

The desire to satisfy pure miserliness, i.e., unreasonable, but insistent abstinence from expenditure as such.

To this, Keynes adds a corresponding list of motives on consumption such as enjoyment, short-sightedness, generosity, miscalculation, ostentation and extravagance.

Subjective motivations also apply to the behaviour patterns of business corporations and governmental bodies. In this respect, Keynes listed the following motives for accumulation:

(a) The Motive of Enterprise:

The desire to do big things, to expand, to secure resources to carry out further capital investment.

(b) The Motive of Liquidity:

The desire to face emergencies and difficulties successfully.

(c) The Motive of Improvement:

The desire to secure a rising income and to demonstrate successful management.

(d) The Motive of Financial Prudence:

The desire to ensure adequate financial provision against depreciation and obsolescence and to discharge debts.

Keynes maintains that the strength of all these motives may vary considerably according to the institution and the organisation of the economic society. Since economic and social institutions and organisations are formed by habits, race, education, morals, present hopes and past experiences, techniques of capital equipment and the prevailing distribution of wealth and established standard of life — all these factors are unlikely to vary in the short run. They, therefore, affect secular progress only very gradually. In other words, these factors, subject to slow change and over a long period, may be considered as given or stable.

Objective Factors:

Objective factors, subject to rapid changes and causing violent shifts in the consumption function, are considered below:

1. Windfall Gains or Losses:

When windfall gains or losses accrue to people their consumption level may change suddenly. For instance, the post-war windfall gains in stock exchanges seem to have raised the consumption spending of rich people in the U.S.A., and to that extent, the consumption function was shifted upward.

2. Fiscal Policy:

The propensity to consume is also affected by variations in fiscal policy of the government. For instance, imposition of heavy taxes tends to reduce the disposable real income of the community; so its level of consumption may adversely change. Similarly, withdrawal of certain taxes may cause an upward shift of consumption function.

3. Change in Expectations:

The propensity to consume is also affected by expectations regarding future changes. For instance, an expected war considerably influences consumption by creating fears about future scarcity and rising prices. This leads people to buy more than they immediately need, i.e., to hoard. Thus, the ratio of consumption to current income will rise, which means that the consumption function will be shifted upward.

4. The Rate of Interest:

In the long run, substantial changes in the market rate of interest may also influence consumption. A significant rise in the rate of interest may induce people to reduce their consumption at each income level, because people will save more in order to take advantage of the high interest rate.

Moreover, if the rate of interest rises, then the lending of the present saving (realised by consuming less) will enable one to obtain an even larger quantity of consumption goods in the future. Keynes, thus, argues that “Over a long period, substantial changes in the rate of interest probably tend to modify social habits considerably.”

In addition to these four factors, Keynes also mentioned changes in the wage level, in accounting practices with respect to depreciation (indicating the difference between income and net income), as the objective factors affecting the consumption function.

Keynes’ disciples, however, considered his list of objective factors inadequate and have listed others which we consider below:

1. The Distribution of Income:

With the given level of income, aggregate consumption will vary if income is distributed in different ways among the people. A community with a greatly unequal distribution of income tends to have a low propensity to consume on the whole, while a community with a high degree of equality of income will have a high propensity to consume in general.

Thus, redistribution of income through fiscal measures of the State will affect the propensity to consume. Joan Robinson explicitly states that “the most important influence on the demand for consumption goods is the distribution of income.” It may be noted here that Keynes does not specify income distribution as an objective factor but includes it under the common heading of fiscal policy.

2. Holding of Saving — Liquid Assets:

According to Kurihara another factor affecting the consumption function is the volume of accumulated savings by the people. The larger the amount of such savings (i.e., holding of liquid assets, like cash balances, savings accounts and government bonds), the more likely people will tend to spend out of their current income, because the holding of savings in the form of liquid assets, will give them a greater sense of security. A change in the real value of such assets held by them, owing to general price changes, might also affect the consumption function.

3. Corporate Financial Policies:

Kurihara observes that business policies of corporations with respect to income retention, dividend payments, and re-investments, produce some effect on the propensity of equity holders to consume. A cautious dividend policy followed by corporations and corporate savings will reduce the consumption function by reducing the residual disposable income of the shareholders (who are consumers, in a way).

All the above-mentioned factors will affect the consumption function in one direction or another. However, all of them are relatively unchanging in the normal short run and, therefore, cannot explain the changes in total consumption during the short-run period. Income is the only variable which will change considerably in the short run and affect consumption. Thus, it may be asserted that consumption varies only in the level of income.