The Tale of the Farmer and the Merchant: The Absolute Income Hypothesis

In the bustling town of Goldshire, two friends, Theo the Farmer and Marcus the Merchant, lived very different lives.

Theo owned a small wheat farm on the outskirts of the town. His income was steady but modest—each season, he sold his crops at the market and earned just enough to feed his family, buy essential supplies, and save a few gold coins for emergencies.

Marcus, on the other hand, ran a thriving trade business. He imported silk, spices, and rare gemstones from distant lands, making large profits with each transaction. With his wealth, he dined at the finest inns, bought luxurious clothes, and even expanded his business.

The Absolute Income Hypothesis in Action

One day, an economist named Sir Keynes visited Goldshire and observed how its people spent money. He noticed an important pattern:

1. Theo, the Farmer, spent most of his small income on necessities. Since he earned less, he could only afford to buy food, basic clothing, and tools for his farm. He saved very little.
2. Marcus, the Merchant, spent lavishly because his income was high. He bought expensive goods, invested in new ventures, and even donated to town projects.

Sir Keynes then formulated a theory: A person’s consumption depends on their absolute income—the more they earn, the more they spend, but not at the same rate.

The Law of Consumption

The economist explained:

• When income is low (like Theo’s), people spend almost everything they earn because they must cover basic needs.
• As income rises (like Marcus’), people still spend more, but they also save a greater portion because their basic needs are already met.

This idea became known as the Absolute Income Hypothesis—the level of a person’s income directly influences how much they spend and save.

The Twist: A Sudden Change in Fortune

One year, Goldshire faced an economic downturn.

• The demand for luxury goods fell, and Marcus’s trade profits declined sharply. With less income, he cut back on his lavish spending—no more exotic silks, no more fine dining.
• Meanwhile, Theo’s situation remained unchanged. He still needed to buy food and farming tools, so his spending stayed stable even though he had little savings.

Sir Keynes observed that rich merchants reduced their consumption drastically when their income dropped, while farmers and laborers continued spending because they had no choice. This reinforced his theory: Consumption is directly related to absolute income, but saving increases as income rises.

The Lesson of Goldshire

The town learned a valuable economic principle that day:

• Low-income earners spend almost all they make—keeping the economy running.
• High-income earners save more as they earn more, which affects overall consumption patterns.
• When income falls, spending drops, affecting businesses and trade.

And thus, the kingdom understood that economic policies should ensure steady income growth to maintain stable consumption and economic prosperity.

Sir Keynes, the visiting economist in Goldshire, not only told a story but also introduced a mathematical way to understand how income affects consumption.

The Consumption Function Formula

Keynes proposed the following equation:

$$C = C_0 + cY$$

Where:

• $C$ = Total consumption
• $C_0$ = Autonomous consumption (the minimum spending required even when income is zero)
• $c$ = Marginal propensity to consume (MPC), which is the fraction of additional income that is spent
• $Y$ = Disposable income

Applying the Formula to Theo and Marcus

Let’s assign values based on their lifestyles:

• Theo the Farmer (Low Income Earner)

  • Autonomous consumption $C_0 = 50$ gold coins (bare necessities)
  • MPC ($c$) = 0.9 (since he spends almost everything he earns)
  • Income $Y$ = 200 gold coins
  • Consumption $C$ = $50 + 0.9(200) = 50 + 180 = 230$
    

  Theo is actually spending more than he earns (dissaving), possibly by borrowing or using savings.

• Marcus the Merchant (High Income Earner)

  • Autonomous consumption $C_0 = 100$ gold coins
  • MPC ($c$) = 0.6 (since he saves more as he earns more)
  • Income $Y$ = 1000 gold coins
  • Consumption $C$ = $100 + 0.6(1000) = 100 + 600 = 700$
    

  Marcus spends a lot, but saves a significant portion (300 gold coins).

Graphical Representation of the Consumption Function

A graph of this function would show:

• A positive slope (as income increases, consumption increases).
• A Y-intercept at $C_0$, meaning even if income is zero, some consumption still occurs (necessities).
• A flatter slope for higher incomes due to lower MPC.

Here is the graph illustrating the Absolute Income Hypothesis through the consumption function. It shows how individuals with different marginal propensities to consume (MPC) respond to changes in income, with Theo having a higher MPC (0.9) and Marcus a lower one (0.6). 

[Economics]