Further, the classical approach is partial in the sense it favors equilibrium between demand and supply forces irrespective of whether such an equilibrium can occur at full employment or less than the full employment level. Since are all E1, E2, E3 equilibrium conditions, the classical wage cut formula may treat any one of these positions as equally satisfactory. But what matters is not equilibrium itself but at what level of effective demand such equilibrium is attained. Therefore the problem of unemployment demands a continuous movement in the direction of higher and higher equilibrium levels (such as E3) to ensure a sufficiently high level of employment. Only then the equilibrium can be said to be general and satisfactory in nature.
(D) Consumption Function: After having established that the level of employment is a function of the level of Effective Demand it is necessary to analyze components of effective demand. If the cause of unemployment is deficiency in effective demand, one might wonder at this point, which component is likely to be deficient. This leads us to Keynes’ income equation :
ED = Y = C + I
In its simplest form total effective demand equivalent to the size of the real national income is composed of two types of expenditure. It is partly made up of C, the consumption expenditure and I the investment expenditure. Let’s begin with the ’C’ component. Keynes at once detects cause of deficiency in the C type of expenditure itself. Consumption is a function of the level of national income Y.
This suggests that as income increases consumption expenditure will increase in (b) proportion where (a) is the initial amount of consumption even when income is zero. Therefore (b) is the propensity or tendency of consumers to spend a certain proportion of the income. If we assume the value of ’b’ as 0.8, it would mean that people spend 80 percent of their income on consumption. If we assume a = 0 then we have :
C = by and where b = 0.8
C = 0.8y
If Y = 100 then :
C = 0.8 (100) = 80
Keynes has further postulated nature of the behavior of the propensity to consume. It is in the form of the law of marginal propensity to consume (MPC). It is known as Keynes’ hypothesis of MPC. It is as follows :
"With every increase in the level of income consumption, expenditure will increase absolutely but will fall relatively."