Consumption is the purchase of goods and services by households. Disposable income is income remaining after deduction of taxes and other mandatory expenses and addition of government transfers, which households can spend or save. The consumption function is the relationship between consumption and disposable income. It is represented by an equation that models the factors that alter consumer spending—the total individual and household purchases of consumer goods and services. The equation indicates a reliance on changing incomes. Keynesian economics uses the concept of the consumption function in order to understand the factors that alter consumer spending.This relationship is typically outlined with a graph of the linear equation:
An increase in disposable income will increase consumption (which, in turn, is a reason for an increase in aggregate demand). Potential increases in consumption include a raise in current or expected future income or a decrease in taxes. All of these factors will increase disposable income. Another factor that will increase consumption will be the desire to save less. This is essentially an increase in MPC, which increases the slope of the consumption function. If these factors move in the opposite direction, it will lead to a decrease in consumption.
Marginal Propensity to Consume
Marginal propensity to consume (MPC) is the portion of disposable income a consumer decides to spend on consumption rather than savings. MPC changes with changes in income.
In the consumption function, MPC is also viewed as the change in C divided by the change in . The formula for MPC is , where is the change in consumption and is the change in disposable income. If an individual receives a windfall of $100 and spends $60 of it, their MPC is 0.6.
MPC is not the same for all consumers. Those with lower disposable income spend a higher percentage of their income on consumption than those who make more money. In other words, poorer households spend more of their disposable income (if they have access to disposable income).