Consumption (economics)

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People buying home electronics at a shopping mall in Jakarta, Indonesia Mall culture jakarta89.jpg
People buying home electronics at a shopping mall in Jakarta, Indonesia

Consumption is the act of using resources to satisfy current needs and wants. [1] It is seen in contrast to investing, which is spending for acquisition of future income. [2] Consumption is a major concept in economics and is also studied in many other social sciences.


Different schools of economists define consumption differently. According to mainstream economists, only the final purchase of newly produced goods and services by individuals for immediate use constitutes consumption, while other types of expenditure — in particular, fixed investment, intermediate consumption, and government spending — are placed in separate categories (see Consumer choice). Other economists define consumption much more broadly, as the aggregate of all economic activity that does not entail the design, production and marketing of goods and services (e.g. the selection, adoption, use, disposal and recycling of goods and services). [3]

Economists are particularly interested in the relationship between consumption and income, as modelled with the consumption function. A similar realist structural view can be found in consumption theory, which views the Fisherian intertemporal choice framework as the real structure of the consumption function. Unlike the passive strategy of structure embodied in inductive structural realism, economists define structure in terms of its invariance under intervention. [4]

Behavioural economics, Keynesian consumption function

The Keynesian consumption function is also known as the absolute income hypothesis, as it only bases consumption on current income and ignores potential future income (or lack of). Criticism of this assumption led to the development of Milton Friedman's permanent income hypothesis and Franco Modigliani's life cycle hypothesis.

More recent theoretical approaches are based on behavioural economics and suggest that a number of behavioural principles can be taken as microeconomic foundations for a behaviourally-based aggregate consumption function. [5]

Behavioural economics also adopts and explains several human behavioural traits within the constraint of the standard economic model. These can range from: bounded rationality bounded willpower, and bounded selfishness. [6]

Bounded rationality was first proposed by Herbert Simon. This means that people sometimes respond rationally to their own cognitive limits, which aimed to minimize the sum of the costs of decision making and the costs of error. In addition, Bounded willpower refers to the fact that people often take actions that they know are in conflict with their long-term interests. For example, most smokers would rather not smoke, and many smokers willing to pay for a drug or a program to help them quit. Finally, bounded self-interest refers to an essential fact about the utility function of a large part of people: under certain circumstances, they care about others or act as if they care about others, even strangers. [7]

Consumption and household production

Aggregate consumption is a component of aggregate demand. [8]

Consumption is defined in part by comparison to production. In the tradition of the Columbia School of Household Economics, also known as the New Home Economics, commercial consumption has to be analyzed in the context of household production. The opportunity cost of time affects the cost of home-produced substitutes and therefore demand for commercial goods and services. [9] [10] The elasticity of demand for consumption goods is also a function of who performs chores in households and how their spouses compensate them for opportunity costs of home production. [11]

Different schools of economists define production and consumption differently. According to mainstream economists, only the final purchase of goods and services by individuals constitutes consumption, while other types of expenditure — in particular, fixed investment, intermediate consumption, and government spending — are placed in separate categories (See consumer choice). Other economists define consumption much more broadly, as the aggregate of all economic activity that does not entail the design, production and marketing of goods and services (e.g. the selection, adoption, use, disposal and recycling of goods and services). [12]

Consumption can also be measured in a variety of different ways such as energy in energy economics metrics.

Consumption as part of GDP

GDP (Gross domestic product) is defined via this formula: [13]

Where stands for consumption.

Where stands for total government spending. (including salaries)

Where stands for Investments.

Where stands for net exports. Net exports are exports minus imports.

In most countries consumption is the most important part of GDP it ranges usually ranges from 45% from GDP to 85% of GDP. [14] [15]

Consumption in microeconomics

In microeconomics, consumer choice is a theory that assumes that people are rational consumers. And they decide on what combinations of goods to buy based on their utility function (which goods provide them with more use/happiness) and their budget constraint (which combinations of goods they can afford to buy). [16] Consumers try to maximize utility while staying within the limits of their budget constrain. Or to minimalize cost while getting the target level of utility. [17] A special case of this is the consumption-leisure model where a consumer chooses between a combination of leisure and working time, which is represented by income. [18]

But based on behavioural economics consumers do not behave rationally and they are influenced by other factors than their utility from the given good. Those factors can be the popularity of given good or its position in a supermarket. [19] [20]

Consumption in macroeconomics

In macroeconomics in the theory of national accounts consumption is not only the amount of money that is spent by households on goods and services from companies. But also the expenditures of government that are meant to provide things for citizens they would have to buy themselves otherwise. This means things like healthcare. [21] Where consumption is equal to income minus savings. Consumption can be calculated via this formula: [22]

Where stands for autonomous consumption which is minimal consumption of household that is achieved always, by either reducing the savings of household or by borrowing money.

is marginal propensity to consume where and it reveals how much of household income is spent on consumption.

is the disposable income of the household.

Consumption as a measurement of growth

Consumption of electric energy is positively correlated with economical growth. As electric energy is one of the most important inputs of the economy. Electric energy is needed to produce goods and to provide services to consumers. There is a statistically significant effect of electrical energy consumption and economic growth that is positive. Electricity consumption reflects economic growth. With the gradual rise of people's material level, electric energy consumption is also gradually increasing. In Iran, for example, electricity consumption has increased along with economic growth since 1970. But as countries continue to develop this effect is decreasing as they optimize their production, by getting more energy-efficient equipment. Or by transferring parts of their production to foreign nations where the cost of electrical energy is smaller. [23] Energy consumption per capita-Iran (Cro).PNG

Determinant factors of consumption

The main factors affecting consumption studied by economists include:

Income: Economists consider the income level to be the most crucial factor affecting consumption. Therefore the offered consumption functions often emphasize this variable. Keynes considers absolute income, [24] Dosnbery considers relative income, [25] and Friedman considers permanent income as factors that determine one's consumption. [26]

Consumer expectations: Changes in the prices would change the real income and purchasing power of the consumer. If the consumer's expectations about future prices change, it can change his consumption decisions in the present period.

Consumer assets and wealth: These refer to assets in the form of cash, bank deposits, securities, as well as physical assets such as stocks of durable goods or real estate such as houses, land, etc. These factors can affect consumption; if the mentioned assets are sufficiently liquid, they will remain in reserve and can be used in emergencies.

Consumer credits: The increase in the consumer's credit and his credit transactions can allow the consumer to use his future income at present. As a result, it can lead to more consumption expenditure compared to the case that the only purchasing power is current income.

Interest rate: Fluctuations in interest rates can affect household consumption decisions. An increase in interest rates increases people's savings and, as a result, reduces their consumption expenditures.

Household size: Households' absolute consumption costs increase as the number of family members increases. Although for some goods, as the number of households increases, the consumption of such goods would increase relatively less than the number of households. This happens due to the phenomena of the economy of scale.

Social groups: Household consumption varies in different social groups. For example, the consumption pattern of employers is different from the consumption pattern of workers. The smaller the gap between groups in a society, the more homogeneous consumption pattern within the society.

Consumer taste: One of the important factors in shaping the consumption pattern is consumer taste. This factor, to some extent, can affect other factors such as income and price levels. On the other hand, society's culture has a significant impact on shaping the tastes of consumers.

Area: Consumption patterns are different in different geographical regions. For example, this pattern differs from urban and rural areas, crowded and sparsely populated areas, economically active and inactive areas, etc.

Consumption theories

Consumption theories began with John Maynard Keynes in 1936 and were developed by economists such as Friedman, Dusenbery, and Modigliani. The relationship between consumption and income was a crucial concept in macroeconomic analysis for a long time.

Absolute Income Hypothesis

In his 1936 General Theory, [27] Keynes introduced the consumption function. He believed that various factors influence consumption decisions; But in the short run, the most important factor is real income. According to the Absolute Income Hypothesis, consumer spending on consumption goods and services is a linear function of his current disposable income.

Relative Income Hypothesis

James Dusenbery proposed this model in 1949. [28] This theory is based on two assumptions: 1- People's consumption behavior is not independent of each other. In other words, two people with the same income that live in two different positions within the income distribution will have different consumptions. In fact, one compares oneself with other people, and what has a significant impact on one's consumption is one's position among individuals and groups in society; Therefore, a person only feels an improvement in his situation in terms of consumption if his average consumption increases relative to the average level of society. This phenomenon is called the Demonstration Effect. 2- Consumer behavior over time is irreversible. This means that when income declines, consumer spending is sticky to the former level. After getting used to a level of consumption, a person shows resistance to reducing it and is unwilling to reduce that level of consumption. This phenomenon is called the ratchet effect.

Intertemporal consumption

The model of intertemporal consumption was first thought of by John Rae in 1830s and it was later expanded by Irving Fisher in 1930s in the book Theory of interest. This model describes how consumption is distributed over periods of life. In the basic model with 2 periods for example young and old age.

And then

Where is the consumption in a given year.

Where is the income received in a given year.

Where are saving from a given year.

Where is the interest rate.

Indexes 1,2 stand for period 1 and period 2.

This model can be expanded to represent each year of a lifetime. [29]

Permanent income hypothesis

Is an economical theory developed by Milton Friedman in 1950s in his book A theory of Consumption Function. This theory divides income into two components is transitory income and is permanent income. Where holds.

Based on changes of income consumption changes as well, but in this theory, it meters which component of income changes. If changes then consumption changes accordingly by . Where is marginal propensity to consume. (If we expect part of income to be saved or invested otherwise ). On the other hand if changes (for example winning lottery). Then this increase in income is distributed over the remaining life span. For example, winning $1000 with the expectation of living for 10 more years. Will result in yearly increase of consumption by $100 [29]

Life-cycle hypothesis

This hypothesis was pubished by Franco Modigliani in 1966. It describes how people make consumption decisions based on their current and future and past income, as they tend to distribute their consumption over their lifetime. It is, in its basic form: [30]

Where is the consumption in given year.

Where is the number of years the individual is going to live for.

Where is for how many more years will the individual be working.

Where is the average wage the individual will be paid over his or her remaining work time

And is the wealth he has already accumulated in his or her life. [30]

Old-age spending

Spending the Kids' Inheritance (originally the title of a book on the subject by Annie Hulley) and the acronyms SKI and SKI'ing refer to the growing number of older people in Western society spending their money on travel, cars and property, in contrast to previous generations who tended to leave that money to their children. According to a study from 2017 that was conducted in the USA 20% of married people consider leaving inheritance a priority, while 34% do not consider it as a priority. And about one in ten unmarried Americans (14 percent) plan to spend their retirement money to improve their lives, rather than saving it to leave an inheritance to their children. In addition, three in ten married Americans (28 percent) have downsized or plan to downsize their home after retirement. [31]

Die Broke (from the book Die Broke: A Radical Four-Part Financial Plan by Stephen Pollan and Mark Levine) is a similar idea.

See also

Related Research Articles

Macroeconomics Study of an economy as a whole

Macroeconomics is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, and government spending to regulate an economy’s growth and stability. This includes regional, national, and global economies. According to a 2018 assessment by economists Emi Nakamura and Jón Steinsson, economic "evidence regarding the consequences of different macroeconomic policies is still highly imperfect and open to serious criticism."

Intertemporal choice is the process by which people make decisions about what and how much to do at various points in time, when choices at one time influence the possibilities available at other points in time. These choices are influenced by the relative value people assign to two or more payoffs at different points in time. Most choices require decision-makers to trade off costs and benefits at different points in time. These decisions may be about saving, work effort, education, nutrition, exercise, health care and so forth. Greater preference for immediate smaller rewards has been associated with many negative outcomes ranging from lower salary to drug addiction.

The theory of consumer choice is the branch of microeconomics that relates preferences to consumption expenditures and to consumer demand curves. It analyzes how consumers maximize the desirability of their consumption as measured by their preferences subject to limitations on their expenditures, by maximizing utility subject to a consumer budget constraint.

Aggregate demand Total demand for final goods and services in an economy at a given time

In macroeconomics, aggregate demand (AD) or domestic final demand (DFD) is the total demand for final goods and services in an economy at a given time. It is often called effective demand, though at other times this term is distinguished. This is the demand for the gross domestic product of a country. It specifies the amount of goods and services that will be purchased at all possible price levels.<refO'Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey: Prentice Hall. p. 307. ISBN 0-13-063085-3. Archived from the original on 2016-12-20. Retrieved 2020-11-05.</ref> Consumer spending, investment, corporate and government expenditure, and net exports make up the aggregate demand.

Normal good Good that increases in demand when incomes rise

In economics, a normal good is a type of a good which experiences an increase in demand due to an increase in income, unlike inferior goods, for which the opposite is observed. When there is an increase in a person's income, for example due to a wage rise, a good for which the demand rises due to the wage increase, is referred as a normal good. Conversely, the demand for normal goods declines when the income decreases, for example due to a wage decrease or layoffs.

In economics, the marginal propensity to consume (MPC) is a metric that quantifies induced consumption, the concept that the increase in personal consumer spending (consumption) occurs with an increase in disposable income. The proportion of disposable income which individuals spend on consumption is known as propensity to consume. MPC is the proportion of additional income that an individual consumes. For example, if a household earns one extra dollar of disposable income, and the marginal propensity to consume is 0.65, then of that dollar, the household will spend 65 cents and save 35 cents. Obviously, the household cannot spend more than the extra dollar. The MPC is higher in the case of poorer people than in rich.

Consumption function

In economics, the consumption function describes a relationship between consumption and disposable income. The concept is believed to have been introduced into macroeconomics by John Maynard Keynes in 1936, who used it to develop the notion of a government spending multiplier.

Utility maximization was first developed by utilitarian philosophers Jeremy Bentham and John Stewart Mill. In microeconomics, the utility maximization problem is the problem consumers face: "How should I spend my money in order to maximize my utility?" It is a type of optimal decision problem. It consists of choosing how much of each available good or service to consume, taking into account a constraint on total spending (income), the prices of the goods and their preferences.

A consumer economy describes an economy driven by consumer spending as a percent of its gross domestic product, as opposed to the other major components of GDP.

In economics, aggregate expenditure (AE) is a measure of national income. Aggregate expenditure is defined as the current value of all the finished goods and services in the economy. The aggregate expenditure is thus the sum total of all the expenditures undertaken in the economy by the factors during a given time period. It is the expenditure incurred on consumer goods, planned investment and the expenditure made by the government in the economy. In an open economy scenario, aggregate expenditure also includes the difference between the exports and the imports.

Revealed preference theory, pioneered by economist Paul Anthony Samuelson in 1938, is a method of analyzing choices made by individuals, mostly used for comparing the influence of policies on consumer behavior. Revealed preference models assume that the preferences of consumers can be revealed by their purchasing habits.

Average propensity to consume (as well as the marginal propensity to consume) is a concept developed by John Maynard Keynes to analyze the consumption function, which is a formula where total consumption expenditures (C) of a household consist of autonomous consumption (Ca) and income (Y) multiplied by marginal propensity to consume. According to Keynes, the individual´s real income determines saving and consumption decisions.

In economics, the life-cycle hypothesis (LCH) is a model that strives to explain the consumption patterns of individuals.

Permanent income hypothesis Economic model explaining consumption pattern formation

The permanent income hypothesis (PIH) is a model in the field of economics to explain the formation of consumption patterns. It suggests consumption patterns are formed from future expectations and consumption smoothing. The theory was developed by Milton Friedman and published in his A Theory of Consumption Function, published in 1957 and subsequently formalized by Robert Hall in a rational expectations model. Originally applied to consumption and income, the process of future expectations is thought to influence other phenomena. In its simplest form, the hypothesis states changes in permanent income, rather than changes in temporary income, are what drive changes in consumption.

Inflationary gap Amount by which the actual GDP exceeds potential full-employment GDP

An inflationary gap, in economics, is the amount by which the actual gross domestic product (GDP) exceeds potential full-employment GDP. It is one type of output gap, the other being a recessionary gap.

Multiplier (economics)

In macroeconomics, a multiplier is a factor of proportionality that measures how much an endogenous variable changes in response to a change in some exogenous variable.

Keynesian cross Formulation of the central ideas in the book The General Theory of Employment, Interest and Money

The Keynesian cross diagram is a formulation of the central ideas in Keynes' General Theory. It first appeared as a central component of macroeconomic theory as it was taught by Paul Samuelson in his textbook, Economics: An Introductory Analysis. The Keynesian Cross plots aggregate income and planned total spending or aggregate expenditure.

In economics, the absolute income hypothesis concerns how a consumer divides his disposable income between consumption and saving. It is part of the theory of consumption proposed by economist John Maynard Keynes. The hypothesis was refined extensively during the 1960s and 1970s, notably by American economist James Tobin (1918–2002).

In economics and other social sciences, preference is the order that a person gives to alternatives based on their relative utility, a process which results in an optimal "choice". Preferences are evaluations, they concern matters of value, typically in relation to practical reasoning. Instead of the prices of goods, personal income, or availability of goods, the character of the preferences is determined purely by a person's tastes. However, persons are still expected to act in their best interest. Rationality, in this context, means that when individuals are faced with a choice, they would select the option that maximizes self interest. Further, in every set of alternatives, preferences arise.

This glossary of economics is a list of definitions of terms and concepts used in economics, its sub-disciplines, and related fields.


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Further reading