Absolute Income Theory

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Absolute Income Theory

The absolute income theory states that consumption is primarily a function of absolute level of the current disposable income. The functional relationship between consumption and income is of such a nature that when current income rises, consumption expenditure also rises, but not in the same proportion as the increase in income. Thus, the fraction of increased income that is devoted to consumption declines with successive increases in the level of absolute disposable income. In technical terms it means the marginal propensity to consume would be less than 1 or
MPC = ΔC/ΔY < 1

Now, when the proportion of additional income devoted to consumption declines with every addition to income, on the average, people would also be spending a smaller proportion of their total income at the higher levels of disposable income than the proportion that they spend at lower income levels. Hence, the average propensity to consume would also be falling.

The consumption-income relationship discussed above can be algebraically shown as
C = a + b(Y)

where ’a’ is the amount of consumption expenditure at zero level of income and ‘b’ is the marginal propensity to consume. It is obvious that even at zero income level, families are households do have some expenditure on consumption as they must somehow maintain themselves even at the barest minimum level subsistence. But beyond a certain level of this minimum consumption addition to income will bring about less than proportional additions to consumptions, as the marginal propensity to consume is less than one declining. Thus, the consumption function is

C = a+ b(Y)
where a > 0
and  0 < b < 1.

Subsequent studies, however, do not support this theory of consumption. If increase in aggregate income of all consumers should lead to a decline in the marginal as well as the average propensity to consume, then the tremendous growth in income over the years should have reduced the average propensity to consume and increased average propensity to save. But the actual data do not support this conclusion. Estimate of national savings and other aggregates made by Kuznets show that aggregate saving ratio and thus also the consumption ratio have remained almost constant since 1870. The consumption function has been empirically observed as if the nature of proportionality, i.e., the consumption has been a constant proportion of national income. Such linear consumption function is expressed as

C = b(Y)

where b is MPC which is constant and does not decline with income.


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