unit 2

UNIT 2 – Consumption

2.1 Introduction

• Definition of Consumption (C):
    - Consumption refers to the expenditure by households on current goods and services to satisfy immediate needs.

• Basic Categories of Consumption Expenditures:
    - (i) Services
    - (ii) Nondurable Goods
    - (iii) Durable Goods

• Important Household Sector Expenditure:
    - Housing investment (purchases of new housing).

Specific Expenditure Categories:

• Food and non-alcoholic beverages

• Alcoholic beverages, tobacco, and narcotics

• Clothing and footwear

• Housing, water, electricity, gas, and other fuels

• Furnishings, household equipment, and routine household maintenance

• Health

• Transport

• Information and communication

• Recreation, sport, and culture

• Education services

• Restaurants and accommodation services

• Insurance and financial services

• Personal care, social protection, and miscellaneous goods and services

• Consumption vs. Savings:
    - When households decide how much to consume, they simultaneously decide how much to save.
    - Total Income Relation:
      - $Y = C + S$
      - If $Y > C$, then $S$ is positive (savings increase/reduce debts).
      - Conversely, if $Y < C$, then $S$ is negative (either reducing savings or borrowing).

• John Maynard Keynes (The Absolute Income Hypothesis):
    - Current consumption is determined by the level of current disposable income.
    - Formula: $C = f(Y)$.
    - The “Consumption Function” is the relationship between planned consumption and current income:
      - $C = f(Y)$.
    - The “Saving Function” represents planned saving based on current income.
    - Note: Saving is a flow (e.g., €50 per month) while savings denote accumulated stock from past savings.
    - Both $C$ and $S$ functions are positively sloped: both increase at higher levels of $Y$.

2.2 Distinction between ‘Average’ and ‘Marginal’ Propensities to Consume and to Save

• Average Propensity to Consume (APC):
    - Represents the fraction/proportion of income consumed; calculated as $ext{APC} = rac{C}{Y}$.

• Average Propensity to Save (APS):
    - Calculated as $ext{APS} = rac{S}{Y}$.
    - At any level of income, the condition is $ext{APC} + ext{APS} = 1$.

• Marginal Propensity to Consume (MPC):
    - Fraction/proportion of any change in disposable income that is consumed; $ext{MPC} = rac{ riangle C}{ riangle Y}$.
    - Focuses on the change in consumption due to a change in income.

• Marginal Propensity to Save (MPS):
    - Fraction/proportion of any change in income that is saved; $ext{MPS} = rac{ riangle S}{ riangle Y}$.
    - Relationship: $ext{MPC} + ext{MPS} = 1$.

Observations from the Data:

1. Consumption $C$ increases directly with income $Y$ in absolute terms.

2. Consumption as a proportion of income decreases at higher levels of economic activity.
     - At higher income levels, APC decreases while APS increases.

3. In low-income situations, where basic necessities prevail, saving may be impossible (indicated by a negative APS).

4. As income rises, discretionary spending increases, enabling saving.

5. As living standards rise, the need to satisfy urgent wants diminishes, making saving easier.

6. In a scenario where MPC and MPS are constant, both consumption and saving functions are linear (Figure 1).

7. Empirical evidence suggests that consumption increases directly with income, but at a decelerating pace where $ext{MPC}$ decreases at higher income levels while $ext{MPS}$ increases (Figure 2).

Table 1 Variables:

2.3 Movements Along vs. Shifts in the Consumption Function

• Movement Along the Consumption Line:
    - Increases in income lead to upward movements along the consumption line.
    - If consumption increases following an income increase, it indicates both consumption and savings rise.

• Shift in the Consumption Function:
    - If consumption increases without an income increase, then savings must decrease or dissaving must increase.
    - Diagrammatically, the consumption function shifts upwards while the savings function shifts down.

Types of Shifts and Pivots:

• Parallel Upward Shift:
    - Implications:
      1. MPC and MPS remain unchanged.
      2. APC rises while APS falls.
      3. Savings become positive at a new higher level of income.

• Upward Pivot:
    - Implications:
      1. MPC increases while MPS decreases.
      2. APC increases while APS decreases.
      3. Savings again become positive but at a higher income level.

• Common Cause for Pivots:
    - Changes in taxation rates typically result in shifts of the consumption function.

2.4 Factors Influencing Consumption (C) and Savings (S) Other than Income (Y)

Wealth

• Households with identical incomes but differing wealth levels tend to have different consumption patterns.

• Greater wealth leads to increased current consumption and expected future consumption.

• Historical Example: Post-1990 real estate price boom where perceived wealth increased household consumption.

Availability of Goods

• An increase in variety of goods available leads to increased consumption.

• Example: The liberalization of imports in Malta in the early 90s spurred consumption levels.

Need

• While need is less impactful long-term, it affects individual/family consumption timing, such as supporting children or furnishing a new home.

Availability of Credit and Interest Rates

• Credit availability permits higher spending potential than current income; high debts may limit consumption.

• Lower interest rates encourage borrowing and spending while reducing incentives to save.
    - Example: Interest rate decrease from 5% to 1% shifts consumption patterns, favoring current consumption over future.

Employment Constraints

• Unemployment affects consumption through budget constraints; limited working hours lead to reduced spending.

Demography

• Changes in the population size and structure influence consumption.

• Certain categories of spending react differently to demographic changes (e.g., food vs. household furnishings).

Direct Taxes

• Reduction in income tax rates increases after-tax wages, leading to higher consumption; functions pivot upwards.

2.5 Other Views on Determinants of Consumption

Relative Income Hypothesis

• Proposed by Duesenberry; consumption is influenced by spending patterns of surrounding peers.
    - A household in a wealthier neighborhood might exhibit higher consumption levels despite identical incomes.

Permanent Income Hypothesis

• Developed by Milton Friedman; states that long-term expected income governs consumption behavior.
    - Non-repetitive income (e.g., bonuses) classified as “transitory” has minimal impact on consumption.

Life-cycle Income Hypothesis

• Introduced by F. Modigliani, A. Ando, and R. Brumberg; suggests consumption depends on long-term income expectations.
    - Young families may dissave while older ages focus on saving for retirement; consumption patterns shift across lifecycle stages.