What’s it: Consumption expenditure refers to the money individuals spend on goods and services. In economics, we can also say it is the residual disposable income after saving. Economists assume individuals allocate their income for two purposes: consumption and saving. So, we can say consumption is the income that remains after we allocate it as savings.
Consumption expenditure includes money spent on three categories: durable goods, non-durable goods, and services. The first two represent tangible products, while the latter are intangible.
In macroeconomics, consumption spending forms aggregate demand, in addition to business investment, government spending, and net exports. So, when it increases, we expect the economy to grow as businesses increase their production to meet higher demand.
Why is consumption expenditure important?
Several reasons why consumer spending is important. First, it affects business profits. When consumer spending is strong, businesses expect to sell more products to generate higher revenues. In addition, they can lower costs through economies of scale by selling more. Finally, increased consumer spending allows businesses to generate more profit.
Second, patterns in consumer spending affect the company’s success. For example, businesses must adapt their products when consumer spending patterns change. By doing so, their products remain relevant to what consumers need. Otherwise, it could fail because consumers are no longer interested in their products. Eventually, they lose sales, and their customers turn to competitors.
Third, consumption expenditure affects economic growth. As mentioned earlier, it forms aggregate demand.
- Aggregate demand = Consumption expenditure + Business investment + Government expenditure + Net exports
When aggregate demand increases, businesses respond by increasing production to earn more profit. As a result, aggregate output increases, and the economy grows (real GDP increases).
In many countries, consumption expenditure contributes significantly to GDP. For instance, in the United States, it accounts for about 60% of GDP, as does the UK. Meanwhile, in Indonesia, it accounts for about 55% of GDP. Because of its significant contribution, governments often focus on spending-side policies to stimulate economic growth.
Fourth, consumption spending affects the unemployment rate. Strong consumption spending encourages businesses to invest in capital goods to increase output. They also recruit more workers. As a result, the unemployment rate falls. And the economy generates more jobs and income.
Fifth, strong consumer spending will drive prices up. Demand increases; therefore, as the law of demand says, prices will also rise. And in macroeconomics, the increase in prices for all goods and services in the economy is called inflation.
What are the 3 types of consumption expenditure?
Based on what consumers buy, consumption expenditure is divided into three categories:
- Durable goods
- Non-durable goods
In marketing, they are referred to as products. The first two represent tangible products, while the latter are intangible products.
Durable goods have a long life span, often three years or more. Examples of durable goods are:
Those items are usually expensive and require more consideration before buying. In addition, consumers usually rely on loans to buy. For this reason, they often cut spending on durable goods the first time the economy starts heading for a recession or when interest rates rise.
Higher interest rates make borrowing more expensive. Finally, consumers put off buying durable goods. Besides being expensive, such items are often less essential – they do not fulfill primary needs. Thus, delaying the purchase is better than having to bear high-interest payments.
Meanwhile, non-durable goods have a short useful life. In fact, some are bought for immediate consumption. We cannot store them for a long time. Food and drink are a good example in this case. In addition to these two, examples of non-durable goods are:
- Dish soap
Finally, services cannot be seen or touched because they are intangible. Instead, we can only feel the benefits. Examples are the services we get from:
- Barber man
- Medical nurse
- Financial planner
Marketing goods is different from services. When selling goods, companies focus their marketing strategy around the marketing mix (product, price, place, and promotion). However, that does not all apply to services because they are intangible. So then, marketers add three variables to the marketing mix, namely people, processes, and physical evidence (called the extended marketing mix).
How do income and taxes affect consumption spending?
Income determines consumption expenditure. Since consumers must pay taxes before spending their income, taxes are another determinant. The difference between the two is called disposable income or after-tax income.
Tax increases reduce disposable income, so people have more money for consumption. Conversely, lower taxes increase disposable income, so people have less money to buy goods and services.
But, is all income spent on consumption? The answer is no. Consumers may set aside some as savings. For this reason, economists categorize spending into two purposes:
Since not all disposable income is allocated entirely to consumption, consumers will divide any extra income for these two purposes. Economists then introduce these two related terms:
Marginal propensity to consume (MPC) – extra disposable income spent on consumption. We get it by dividing the change in consumption by the change in disposable income.
Marginal propensity to save (MPS) – the extra disposable income spent on saving. We get it by dividing the change in saving by the change in disposable income.
What factors affect consumption expenditure?
In addition to disposable income (including taxes), other factors influence consumption expenditure, including:
Wealth. Net worth equals total assets minus liabilities. If asset prices rise, consumer wealth increases – assuming liabilities do not change, prompting them to increase consumption. Economists refer to the relationship between the two as the wealth effect.
Future income expectations. When consumers see their future income unchanged, they dare to take out a loan, for example, to buy a car. Likewise, when they believe their future income will increase, they increase spending. On the other hand, when their future income prospects deteriorate, they will delay consumption and save more to deal with a worse situation.
Price expectations. When future prices rise, consumers will shop now before prices become more expensive. On the other hand, if future prices fall, they will delay buying to get a lower price.
Interest rate. Low-interest rates will encourage consumers to be willing to take out loans to buy durable goods. Conversely, if interest rates rise, they think twice about applying for a new loan because borrowing costs go up. So, they may delay the purchase.
Interest rates are also closely related to credit availability. When interest rates are low, credit availability increases. That’s because the economy’s liquidity (measured by the money supply) increases.
How does consumption spending affect the economy?
Consumption spending is a key indicator to measure the economy’s strength. When consumers are confident in their spending, we expect the economy to continue to grow. This is because their strong consumption creates more demand for goods and services.
Strong demand encourages businesses to increase production. They are also confident in investing in capital goods and recruiting new workers. Finally, the economy grows as output increases. In addition, the unemployment rate also decreases. This creates a more prosperous economy where more jobs and income are created.
Job creation and more income make consumers more optimistic. Finally, they increase consumption. Stronger demand prompts businesses to increase production further, driving economic growth higher.