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Theories Of Consumption Behaviour Notes

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Pip Reeve

10.02.2009 Describe and contrast the various theories of consumption behaviour.

Many economists have written about the theory of consumer behaviour in an attempt to interpret data on the relationship between income and consumption. In this essay I will explain the findings of six prominent economists in this area, and I will contrast the similarities and differences between their results. Firstly, I will discuss Keynes' General Theory which was published in 1936. Keynes had three main conjectures about the consumption function, which he made from casual observation and introspection, due to a lack of sophisticated technology and data which is available to economists today. The first of these conjectures is that the marginal propensity to consume is between zero and one. Keynes called this the 'fundamental psychological law' and this suggested that as income increased, consumption increased also, but not by as much as the increase in income. The second conjecture was that the average propensity to consume, which is the ratio between consumption and income, falls as income rises. This suggests that saving is a luxury good, and therefore the rich are more likely to save a higher proportion of their income. The third conjecture is that income is a primary determinant of consumption and interest rates are relatively unimportant. This contrasts with the classical economists who preceded Keynes who believed that a higher interest rate encouraged saving and discouraged consumption. Keynes stated that this could possibly be the case in theory but in the short run at least, interest rates are relatively unimportant in determining consumption. So, Keynes consumption function is:

This means that Keynes believed that the average propensity to consume is:

The following graph shows these three conjectures:

At first, the empirical data suggested that Keynes consumption function was a good approximation of the relationship between consumption and income. The data showed how households with a higher income consumed more, so the marginal propensity to consume was greater than zero. Next, the data showed that households with a higher income saved more, so marginal propensity to

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