Psychological Law of Propensity to Consume

Keynes’ Psychological Law of Propensity to Consume describes how people change their consumption when their income changes. It says that as income increases, people do spend more, but they do not spend the entire additional income on consumption; they also increase their saving.​

This law is also called Keynes’ Fundamental Law of Consumption and is a key part of his theory of income and employment.​

“The psychology of the community is such that when aggregate real income is increased, aggregate consumption is also increased, but not by so much as income.” — Keynes

1. Constancy of Psychological–Institutional Complex

Factors like habits, tastes, customs, income distribution, price level, and population do not change in the short run. Consumption depends on income alone.

2. Normal Conditions

The economy is free from abnormal situations such as war, revolution, hyperinflation, or floods. Under such emergencies, people may spend their entire income, breaking the law.

3. Rich Capitalist Economy (Laissez-faire)

The law applies to a free-market capitalist economy with minimum government interference. In a poor economy, almost all income goes to consumption; in a heavily regulated one, government controls can alter saving–spending decisions.

Keynes explained his law through three related propositions.​

1. When income increases, consumption increases but by a smaller amount

• As income rises, consumption expenditure also rises, but not in the same proportion.
• Once basic needs are largely satisfied, each extra rupee of income is partly used for extra consumption and partly added to saving, so the marginal propensity to consume is less than one.​

2. Increased income is divided between consumption and saving

• The increment in income is split into two parts: an increment in consumption (ΔC) and an increment in saving (ΔS).
• Symbolically, this can be written as:
  ΔY = ΔC + ΔS​
• The part that is not spent on consumption automatically appears as saving.

3. Higher income does not reduce total consumption or total saving

• When aggregate income increases, both total consumption and total saving in the economy tend to rise.
• It is highly unlikely that, with a higher income, people will reduce either their overall consumption or their overall saving; at worst, one of them may remain constant in the short run.​

This schedule shows that as income increases, both consumption and saving increase, but the share of income going to saving becomes larger over time.

• The 45° line from the origin represents all points where income equals consumption (Y = C), so saving is zero on this line.​
• The upward‑sloping line C is the consumption function. At low income level Y₀, consumption E₀Y₀ is greater than income; the vertical segment E₀P₁ shows dissaving, equal to S₀Y₀ on the saving curve.​
• At income level Y, point E lies on both the 45° line and the C curve; here income equals consumption and saving is zero. This is the break‑even point.
• At higher income level Y₁, consumption E₁Y₁ is less than income Y₁P₂; the vertical gap between the 45° line and the C curve (shown as E₂E₁ or S₁Y₁) represents positive saving.

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Thus the diagram visually confirms the law: as income rises, consumption rises but the gap between income and consumption (saving) becomes larger.

1. Critical Importance of Investment

Consumption is stable in the short run, so income and employment can only rise through more investment.

2. Refutation of Say's Law

Say's Law says "supply creates its own demand" (MPC = 1). Since MPC < 1, not all output is consumed → demand can fall short of supply → Say's Law is invalid.

3. Declining Marginal Efficiency of Capital (MEC)

Rich communities save more → aggregate demand falls → prices fall → profits fall → expected return on capital (MEC) declines.

4. Under-Employment Equilibrium

AD = AS can occur below full employment because consumption (and therefore AD) is not large enough to absorb full-employment output.

5. Income-Generation Process (Multiplier)

Because MPC < 1, each spending round is smaller → income rises in diminishing steps → this is the multiplier process.
\[K=\frac{1}{1-MPC}\]
Example: If MPC = 0.8, then K = 5. A ₹100 crore investment creates ₹500 crore of income.​

6. Over-Saving Gap

In rich economies, saving grows faster than investment opportunities → excess saving → fall in AD → danger of economic crash.

7. Secular Stagnation

Long-run problem: if growing savings cannot find investment outlets, the economy faces prolonged depression and unemployment.

8. Need for State Intervention

Free markets cannot automatically close the saving–investment gap → government must boost consumption in recession and control it in inflation.

9. Wages and Employment Controversy

Wage cuts reduce income of workers (high MPC) → AD falls → depression worsens. So, unlike classical belief, cutting wages does not increase employment.

10. Unique Nature of Income Propagation

People save part of extra income → each successive spending round is smaller → income propagation is gradual and finite, explained by the multiplier.

11. Turning Points of Business Cycles

During a boom, consumption lags behind rising income → saving gap grows → overproduction → downturn begins before full employment is reached.

• Consumption increases when income increases, but less than income.
• Part of the extra income is saved.
• MPC < 1 (Marginal Propensity to Consume is less than one).
• Formula: ΔY = ΔC + ΔS
• Break-even point: Income = Consumption (Saving = 0).
• Higher income → higher savings.
• Investment and government action may be needed to maintain demand.