Businesses typically examine changes in the economy when planning for the future. Shifts in consumer spending are particularly important to follow because they can slow the economy or speed it up. Increases in consumer spending usually encourage businesses to invest more in jobs, equipment and resources. The consumption function is an economic formula that connects total consumption and gross national income. The consumption function allows businesses and others to track and predict overall spending and its impact on the economy.
British economist John Maynard Keynes created the consumption function formula, which calculates consumer spending based on income and the changes in income – spending rises or falls in proportion to income. The consumption function determines consumer spending based on three factors.
Essential spending, like on food, clothes or housing, occurs even without income. Such spending can come from savings or from borrowing. The consumption function formula assumes that such autonomous consumption remains constant.
Keynes assumed that consumption doesn’t increase at the same rate as income. When people get more money, they spend some and save the rest. The marginal propensity to consume is the portion of each additional dollar that a consumer spends. Lower-income people tend to spend a higher proportion of their additional income. People with higher incomes save a greater percentage.
The consumption function considers the amount of income that consumers have to spend after taxes. This includes money that they will spend on bills. This total changes as people make more money, like when their employers raise their salaries, or when they earn less, such as when companies reduce wages or lay off workers.
The consumption function is calculated by first multiplying the marginal propensity to consume by disposable income. The resulting product is then added to autonomous consumption to get total spending. As an equation in which C = consumer spending; A = autonomous consumption; M = marginal propensity to consume; D = real disposable income, it is: C = A + MD.
Businesses and others, such as fiscal policymakers, can project shifts in consumer spending based on changes to one or more of the factors in the consumption function. For example, given that people with low income are likely to spend a greater percentage of any additional income, they will likely spend more money if their income taxes are reduced because their disposable incomes will increase. However, people with higher incomes would likely save a larger portion of the extra income that they would get from a tax cut.