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Consumption

The use of goods and services by a household

What is Consumption?

Consumption is defined as the use of goods and services by a household. It is a component in the calculation of the Gross Domestic Product (GDP). Macroeconomists typically use consumption as a proxy of the overall economy.

When valuing a business, a financial analyst would look at the consumption trends in the business’ industry. It is an important step, as it helps the analyst with the assumption section of the financial model.

 

Consumption -Arm holding shopping bags

 

Consumption in Neoclassical Economics

Neoclassical economists view consumption as the final purpose of an economic activity, hence the per person value is an important factor in determining the productive success in an economy.

Macroeconomists use the economic measure for two reasons. The first is to assess aggregate savings in each household; savings refer to the portion of income that is not used for consuming goods and services. Aggregate savings in the economy feeds into the national supply of capital; hence, it can be used to assess the long-term productive capacity of an economy.

Secondly, consumption behavior provides a good measure of the total national output in the economy. The total output can be used to understand the reasons for macroeconomic fluctuations in the business cycle.

The behavior data can be used to measure poverty, understand the retirement rate in households, and test theories of competition in the economy. Data from households allows macroeconomists to understand spending behavior, and the figures can be used to examine relationships between consumption and behaviors such as unemployment and education costs.

 

Importance of Consumption

Modern economists give a lot of importance to the level of consumption in the economy because it characterizes the economic system the country currently operates in.

 

1. The beginning of all economic activity

Consumption is the start of all human economic activity. If a person desires something, he will take action to satisfy this desire. The result of such an effort is consumption, which also means the satisfaction of human wants.

 

2. End of economic activities

If, for example, a person desires a sandwich, they will take the effort to make the sandwich. Once it is made, the food is consumed, resulting in the end of an economic activity.

 

3. Consumption drives production

According to economist Adam Smith, “Consumption is the sole purpose of all production.” It means that the production of goods and services is dependent on the level of consumption.

 

4. Economic theories

The study of consumption theory has helped economists formulate numerous theories such as The Law of Demand, Consumer Surplus concept, and the Law of Diminishing Marginal Utility. The theories help understand how individual behavior affects the input and output in the economy.

 

5. Government theories

Consumption habits also help the government formulate theories. The minimum wage rate and tax rate are determined based on the habits of individuals. It also helps the government make decisions on the production of essential and non-essential commodities in a country. It also provides the government with insight into the saving to spending ratio in the economy.

 

6. Income and employment theory

Consumption plays an important role in the income and employment theory under Keynesian economics by John Maynard Keynes. The theory states that if consuming goods and services does not increase the demand such goods and services, it leads to a fall in production. A decrease in production will means businesses will lay off workers, resulting in unemployment. Consumption helps determine the income and output in an economy.

 

Consumption Cycle

 

Consumption and the Business Cycle

Consumption expenditure in the private sector accounts for two-thirds of the Gross Domestic Product (GDP). The remaining one-third constitutes government expenditure and net exports. Private consumption is divided into three categories: Durable goods that are defined as goods with a lifetime greater than three years, services that include travel and car repairs, and non-durable goods such as food and water that can be immediately consumed.

The consumption flow and expenditure (consumption expenditure) can help understand the fluctuations in the business cycle. Producers of durable goods only earn income from the sale of the initial product (expenditure), not from consuming the services following the purchase.

Hence, it is expenditure and not consumption flow that determines short-term economic prosperity. Due to the nature of durable goods, economists have created a rational optimization framework to account for the goods. During an economic downturn, consuming durable goods decreases because the goods require a significant investment, and consumers will put off the purchases until economic conditions improve.

When the economy recovers, spending on durable goods increases and becomes more volatile than spending on non-durable goods. It is because an investment in durable goods is induced by simply contemplating a purchase to actually making the purchase. This is why a change in interest rates, tax rates, or other stimulus measures affect spending on durables than any other kind of spending.

 

Additional Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Consumer Surplus Formula
  • Marginal Propensity to Consume
  • Network Effect
  • Normal Goods

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