What are the Implications of the Psychological Law of Consumption?
Saving = Income – Consumption Expenditure or,
S = Y – C.
The gap of income over consumption expenditure leads to a deficiency in demand if it is not filled through investment. In other words, savings need to be mobilized and injected back into production system. Such injections are called investment. Thus,
I = S = Y – C,
For equilibrium if injections (I) lag behind the withdrawals (S), depression is not far behind. If S is not properly mobilized and injected back, the only alternative is to increase C. This is possible only through high propensities (APC and MPC) to consume. Both need to be very high for this purpose.
It would be in order to demonstrate the relationships between average and marginal propensities to consume and to save here (see Table 4.1) for proper understanding of the two.
Y = C + S
Y / Y = C / Y + S / Y
1 = APC + APS
(Dividing by y on both the sides)
Where, APC = Average Propensity to Consume (C/Y)
And, APS = Average Propensity to Save (S/Y)
Thus, APC must be very high and APS very low particularly when mobilization and injection of savings is low. In like manner, even MPC must be very high and MPS very low as shown below.
At an initial stage, let Y1 = C1 + S1
At a later stage, let Y2 = C2 + S2
Subtracting, Y2 – Y1 = C2 – C1 + S2 – S1
= ?Y = ?C + ?S
= ?Y / ?Y = ?C / ?Y + ?S / ?Y
1 = MPC + MPS
Note that high values of MPC and APC (ideally, 1 each) ensure low (ideally, 0) level of leakages from the circular flow of income and expenditure. Recall that Keynesian Theory holds the leakage from the circular flow responsible for the onset of depression.
In other words, if MPC and APC are each unitary (i.e., APS and MPS are each zero), the circular flow of income and expenditure is perfect and the question of onset of depression would never arise.
Since increase in consumption expenditure lags behind the increase in the income, the marginal efficiency of capital experiences a downward pressure due to lagging consumption demand. This affects the profitability and hence the investment adversely.
2. The law explains the turning points in the trade cycles. A downturn from the boom begins when increase in consumption expenditure is much less than an increase in income. In the same way, an upturn from depression begins when the consumption expenditure cannot be reduced in the same proportion in which people’s income decreases.
3. Income of the people does not increase in the same proportion in which supply of money increases because people do not increase consumption expenditure in the same proportion in which income increases.