The following points highlight the seven major importance of Keynes Psychological Law of Consumption. The importance are: 1. Vital Importance of Investment 2. Repudiation of Say’s Law 3. Decline in MPC 4. Over Saving Gap 5. Income Generation 6. Turning Points of Trade Cycle 7. Underemployment Equilibrium.
Importance # 1. Vital Importance of Investment:
One of the most important implications of Keynesian psychological law of consumption is that it establishes the vital and crucial role of investment when the community spends less than the increment in income.
Increased output and employment will not be possible to maintain, unless investment (on capital goods) is sufficient to fill the gap between income and consumption.
The existence of such a gap implies that sales fall short of costs necessary to provide current output; with the consumption function becoming stable, the fluctuations in income, output and employment are to be sought in the instability of investment. Thus Keynes’ consumption functions and its stable nature, especially in the short run, clearly brings out the strategic importance of investment in any kind of income analysis.
Importance # 2. Repudiation of Say’s Law:
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Keynes’ Law explains general over-production and general unemployment. The marginal propensity to consume of less than unity explains that the whole production (income) is not automatically spent. In other words, entrepreneurs fail to receive, by means of sales, an amount that must be had to justify current output; supply fails to create its own demand and exceeds the demand simply to create a glut of goods and services thereby leading to general unemployment. Thus, the assumption of MPC being less than one helps us to invalidate Say’s Law of Markets. It is contended that in the long period the demand is likely to be sufficient to buy all that economy is capable of supplying.
This long term adjustment is brought about by the market forces of demand and supply: Consumption function tells us that this is true only as far as increasing income is spent on consumption. Keynes’ consumption function attempts to show that there is nothing automatic about the adjustment process as the income created is separated from spending both in time and in space.
Importance # 3. Decline in MPC:
The expected rate of profitability or the marginal efficiency of capital may decline with consumption remaining unchanged failing to rise as much as the rise in income. Declining tendency of the marginal efficiency of capital could be avoided if consumption spending could be increased at the same rate as an increase in income.
If demand for investment were to be guided entirely by the rate of interest, as some seem to suppose, then stable consumption function will present no problem. But there is no reason or evidence to show that investment opportunities are unlimited even at the lowest possible rate of interest. Therefore, the implication of stable consumption function is that it tends to lower the MEC and investment in the short run.
Importance # 4. Over Saving Gap:
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If consumption spending does not rise with a rise in income, then a permanent over saving gap may come to exist. Over saving gap refers to the difference between the amount people wish to save (out of full employment income) and the volume of private investment. For example, if people want to save Rs. 60 crores out of a full employment income of Rs. 300 crores and businessmen find it profitable to invest only Rs. 40 crores (according to the existing investment opportunities), then there will be an over saving gap of Rs. 20 crores annually.
The propensity to consume being less than one creates a knotty problem of offsetting a large amount of saving to maintain full employment. In the absence of sizable investment opportunities in the face of stable consumption function, it may not be easy to wipe off this over saving gap. A real solution lies in somehow raising the consumption function.
Importance # 5. Income Generation:
MPC of less than unity also accounts for the unique and the slow nature of income propagation. Whenever purchasing power is injected into the income stream, it will lead to smaller and smaller successive increments of income. This is on account of the stable consumptions function and the MPC being less than one. Since the income receivers will spend less than the full increment of income, the magnitude or the value of the multiplier will be extremely limited, and the process of income generation would be dampened.
Importance # 6. Turning Points of Trade Cycle:
MPC being less than one also helps us to explain the turning points of the business or the trade cycle. It enables us to know how upswings and downswings in business are caused. The traditional or classical theory based on Say’s Law of Markets also explained fluctuations in business. But the explanation was based on the presence of ‘bottlenecks’ or the ‘shortages’ of the factors of production like raw material, power, equipment, transport, etc.
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At the same time, the high rate of interest, wage-price and cost rigidities, inflexible credit system were cited as causes. But all these factors did not explain clearly the turning points in the business cycle. The upper turning point of the business cycle (i.e. from boom to depression) or lower turning point i.e., from depression to prosperity) are now explained by the limits set by the MPC being less than one i.e., people failing to spend on consumption the full increment of income. This leads to fast piling up of savings which remain un invested at the crest of the boom and income starts falling down. Further, the lower turning point or an upturn from depression to recovery and prosperity is explained in terms of the failure of the people to curtail their consumption to the full extent of the decrement in income.
Income level cannot fall below the level of consumption. People always have a minimum standard which they would maintain at all cost in the short run. Let this level be called C. During depression, investment may fall to zero but consumption can at the most fall to C(Y=C). This forms the basis of the lower turning point.
Importance # 7. Underemployment Equilibrium:
Keynes’ stable consumption function gives rise to another implication called ‘underemployment equilibrium.’ We have already known that the point of effective demand is the point where the economy is in equilibrium, though not necessarily in full employment equilibrium. The reason is that MPC being less than one, consumers fail to spend on consumption as much as the increase in income. Saving is in appreciable amount at full employment and does not get invested due to which income falls. Hence, what we have in the economy is the underemployment equilibrium.
This law helped to overthrow the Say’s Law of Markets and established the crucial role of investment for increasing employment. However, the greatest contribution of this law lies in explaining the upper and lower turning points of a business cycle. Before Keynes’ Law of consumption no convincing explanation of the turning points of business cycles could be given. By developing the Psychological Law of Consumption and assuming MPC to be less than one, Keynes was able to put his finger on one of the major determinants of effective demand and was able to show the possibility of ‘general overproduction’ and ‘general unemployment’.
It is on account of this that A H. Hansen has regarded consumption function as “an epoch making contribution to the tools of economic analysis.” He regarded it even more important than Marshall’s discovery of the demand and supply ‘cross’. Keynes’ invention of the consumption function can indeed be regarded as one of the major landmarks of modern economics. Harris regards it one of the corner-stones of the Keynesian structure, a concept which has stood the scrutiny well.