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# Consumption function basics

The basic idea of a consumption function. Created by Sal Khan.

Video transcript

Male: What I want to do in
this video is introduce you to the idea of a consumption function. It's a very simple idea. It's really just the notion that income, income in aggregate in an economy can drive consumption in
aggregate in an economy. Just to make things
tangible, I will construct a consumption function for
a hypothetical economy, and we can debate whether we
can construct a better one. All the numbers don't have to be exactly what I'm about to do, but this is just to make things concrete in your mind. Maybe we have a hypothetical economy where consumption is
going to be equal to ... well, maybe there's some
base level of consumption even if there's no aggregate
income in our economy. It's hard to image, but
let's say there isn't. There will still be consumption. Maybe people can do it by
digging into their savings. They're essentially using resources that they've already
accumulated in some way. Let's say that base level of consumption, let's call that 500. It could be billions of
dollars or gold coins or clamshells or whatever the unit of measuring economic
activity is in our economy. That's our base level of consumption. Then let's say if there
is some aggregate income, people will spend 60% of it. I'm just picking these
numbers somewhat arbitrarily. Let's say if there's some above and beyond the base level, they're going to spend 0.6 of any aggregate income they have. Actually, to be a little
bit more particular, I'll write not just income,
I'll write disposable income. I'll want to do that in a different color. They will ... that's
not a different color. Above and beyond the base level, they'll spend 60% of
their disposable income. I make the distinction,
just to clarify our model, between income and disposable income because all of the aggregate
income in an economy does not end up in consumers' pockets. Just for a simplification, you might say, "Yeah, some of it ends
up in firms' pockets," but the firms, at the end of the day, are owned by individuals, so it can end up in individuals' or consumers' pockets. But some of it goes off to the government. When you think about
income, and if you spend any time looking at
your pay stub this will become familiar to you,
you have your income but you don't end up
with all of that in your checking account or your pocket or your savings account. A good fraction of that
is taken out for taxes. What you have left over when you subtract taxes out of income, that
is your disposable income. That's why I write this
here because that's actually a more reasonable thing to say. People will spend 60% of
their disposable income. They obviously can't spend
a fraction of stuff that they don't have, the stuff
that's taken out for taxes. Just to visualize this, we can draw it. This will be a line. This might ring a bell from
your early algebra days. Just the variables are different. Instead of a y, we have a c, but that's still the dependent variable. It's a function of disposable income. In algebra you'll often call
this the independent variable. The most typical variable is x. It's really the same idea over here. Let me draw this a little bit neater. We can graph this, what's
essentially going to be a line. It doesn't have to be a line. We just constructed a consumption function that happens to be a line. This is consumption right over
here in the vertical axis. That could be in billions of dollars or clamshells or whatever else. Then right over here we
have disposable income. If there is zero disposable income, maybe I'll draw a little table over here. This is I'll call it disposable income and this is consumption. If there's zero disposable income, then this whole term right over here is 0. Then you have 500 billion dollars, or whatever our units
are, of base consumption. This would correspond to
this point right over here. In the horizontal axis
you don't move at all because this is 0. Vertical axis is 500. So you have 500. Let's say disposable income is 1,000 whatever our units are. So this is 500. Let's say this is 1,000
billion clamshells. This could be in billions of clamshells. I don't want to keep having to say that over and over again. What is our consumption
going to be in our units? Our consumption is going to be equal to 500 + 0.6 x 1,000 which is equal to 500 + 600 which is equal to 1,100. That would correspond,
this right over here, would correspond to; so 1,000, so this might be 1,000 on this axis so this would be 1,100 to
this point right over here. That would be the
coordinate: 1,000; 1,100. This is a line. Two points make a line. In this particular case we have a consumption function that looks something like this. We picked two points to draw it. If you remember a little
bit of your slope, you could view this as your y intercept, or in this case your c intercept, and that your slope would be the .6, and we'll talk more about
that in future videos when we dig into the marginal propensity to consume a little bit more. But the one thing I just want to highlight is it's a very simple idea. This does not have to be
the consumption function. The consumption functions
that we tend to study in introductory economics
classes will look like this. It will be a line that
has some intersection, some base level of consumption. But one could argue it
might be very different. Maybe the consumption
function looks like this. Maybe when income is low, for every incremental dollar of income, people are probably going to spend a lot. As they become richer
and richer and richer, as their income goes higher and higher, they're going to spend less and less a fraction of their disposable income. Essentially what I'm describing here is a marginal propensity
to consume changes. In our first model, we had a very basic marginal propensity to consume. It was constant. For every incremental
dollar, .6 of that got spent. So we had a marginal propensity to consume that was constant of 0.6. Marginal propensity to consume. But, you could argue, that maybe a more complex model is justified. That when you have a very high marginal propensity to consume, when
people have very little because they have a very
low standard of living, they really want to just
get a little bit more just so they can live a decent life, but as they get more and
more income they say, "Hey, I'm starting to max
out my standard of living, "I'll save more and more
of it for a rainy day."