2a. Consumption

Consumption and saving

  • Consumption in economics is spending on consumer goods and services over a period of time.
  • Saving is what is not spent out of income. This might take the form of cash or as money in a bank account
  • Income is money made from work

Consumption can be broken down into a number of different categories. One way is to distinguish spending between goods and services. Another way is to distinguish between spending on durable and non-durable goods.

  • DURABLE GOODS - Durable goods which, although bought at a point in time, continue to provide a stream of services over a period of time. A car might last for 6 years or a television could last for 10 for example

  • NON-DURABLE GOODS - Non-durable goods are goods that are used up immediately or over a short period of time such as an ice cream or washing up liquid.

Marginal propensity to consume

The marginal propensity to consume (MPC) is the proportion of a change in income that is spent.

MPC = Change in consumption / Change in income

If the £200 rise in income leads to a £150 rise in consumption then the marginal propensity would be 0.75 (£150/£200).

For an economy as a whole, the marginal propensity is likely to be positive (i.e. greater than zero) but less than 1. Any rise in income will lead to more spending but also some savings too.

For individuals, the marginal propensity could be more than 1 if money was borrowed so that spending is higher than income.

Average propensity to consume

The average propensity to consume (APC) measures the average amount spent on consumption out of total income

For example, if total disposable income in an economy were £100bn and consumption were £90bn then the average propensity to the consumer would be 0.9.

APC = Consumption (C)/ Income = (Y)

In a rich industrialized economy, the APC is likely to be less than 1 because consumers will also save part of their earnings.

What can affect consumption?

  • Wealth
  • Inflation
  • Interest rates
  • Availability of credit
  • Expectations
  • The composition of households
  • Changes to tax rates

Wealth

The wealth of a household is made up of two parts. Physical wealth (houses, cars, furniture etc.) and monetary wealth (cash, money in bank, stocks etc.).

If the wealth of a household increases, consumption will increase. This is known as the wealth effect. There are two important ways that the wealth of households can change over a short period of time.

  • A change in house prices - If the real price of houses increases considerably over a period of time, households feel able to increase spending. They do this mainly by borrowing more money secured against the value of their house.
  • A change in the value of stocks and shares - Households react to an increase in the real value of a household’s portfolio of securities by selling part of the portfolio and spending the proceeds.

Inflation

Inflation has two effects on consumption:

If households expect prices to be higher in the future they will be tempted to bring forward their purchases.

Or

Rising inflation tends to erode the real value of monetary wealth. Households react to this by attempting to restore the real value of their wealth, saving more, and reducing consumption.

The rate of interest

Households rarely finance expenditures on non-durables such as food

or entertainment by borrowing money. However, they will do this for durable goods and the lower the interest rates, the less a household will have to pay over time. If interest rates go up, households tend to stop spending. When interest rates are low, households should spend more

The availability of credit

The rate of interest determines the price of credit. However, the price of credit is not the only detriment of how much households borrow.

  • Governments can impose restrictions on the availability of credit – for instance they have imposed maximum repayment periods and minimum deposits.
  • Abolishing restrictions means that households increase their debt and spend the proceeds. Making credit more widely available will increase consumption.

Expectations

Expectations of prices tend to make households bring forward their purchases and thus increase consumption.

Expectations of large increases in real income will also encourage people to borrow money.

This works the opposite way when times are tough – people will stop spending if unemployment is rising

The composition of households

Young people tend to spend a higher proportion of their income than those in middle age.

With more income available, households often choose to build up their stock of savings in preparation for retirement. When they retire they will run down their savings to supplement their pension.

The more young and old households, the greater the level of consumption.