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What’s is: Household consumption refers to the final household expenditure on goods and services. Items can be classified as durable goods, nondurable goods, and services.
Household consumption is a key indicator for analyzing economic demand. Consumption usually accounts for a large percentage of gross domestic product (GDP). In fact, in some countries, the percentage reaches more than 50%.
Factors Affecting Household Consumption
Income is the main determining factor for household consumption. Without income, households do not have money to buy goods and services.
Apart from income, other factors affecting household consumption are:
- Wealth
- Future income expectation
- Interest rate
- Inflation
- Income distribution
- Demographic factors
- Tastes and preferences
Disposable income
In macroeconomics, among several variables, disposable income is the primary determinant of consumption. Economists state household consumption as a function of disposable income.
We calculate disposable income by deducting the tax from household income. Income here includes those received from transfer payments.
- Disposable income = Income – Tax
Thus, disposable income increases when:
- Pre-tax income increases
- Income tax is down
From disposable income, households have two main choices, save or consume. An additional 1 dollar of income allocated to consumption refers to the marginal propensity to consume (MPC). Meanwhile, the extra saved is referred to as the marginal propensity to save (MPS).
MPC plus MPS must be equal to 1. The concept of MPC is useful for explaining the multiplier effect of consumption on the economy. A high MCP increases the impact of consumption on the economy.
- Multiplier = 1 / (1-MPC)
Wealth
Household wealth consists of real assets and financial assets. When the prices of assets such as stocks and bonds rise, household wealth increases.
Higher wealth encourages households to spend more. When their assets increase, they feel they have hit their wealth-gathering target. Therefore, they will spend any additional income on the consumption of goods and services.
We call the relationship between asset prices and expenditure the “wealth effect.”
You need to remember. In this case, we assume that the liabilities (such as a mortgage loan) do not change.
Future income expectation
Household optimism affects spending behavior. If households are optimistic that their future income will increase, current spending will increase. This condition generally occurs when economic growth is expanding.
Economic expansion brings more prosperous conditions. The unemployment rate is low, and the income outlook is improving.
Conversely, during a recession, the downward pressure on income and consumption increases. Households are becoming more pessimistic about their jobs and income. Shrinking economic activity indicates that businesses are likely to cut their labor, pushing the unemployment rate higher.
Interest rate
Interest rates affect household consumption and saving behavior. An increase in interest rates stimulates households to save more to obtain higher interest income. As households save more, the allocation for consumption is reduced.
Interest rates also increase borrowing costs. Households often rely on bank loans to purchase items such as cars and houses. Consequently, when interest rates rise, they tend to delay such purchases.
Conversely, lower interest rates reduce borrowing costs. Households will usually apply for new loans to facilitate the purchase of durable goods.
Also, low interest rates mean low-interest income. As a result, they are likely to save less.
Inflation rate
Inflation and its expectations influence consumption decisions, primarily through their effect on real income and the real interest rate.
For example, when households expect higher inflation in the next month, they are more likely to buy durable goods now. That’s because current income has a greater purchasing power than in the future.
Conversely, if households expect deflation (falling prices) next month, they will postpone their current purchases. They will buy in the next month, hoping to get lower prices.
Income distribution
Income distribution refers to how total income is divided among the population. It’s a crucial factor influencing household consumption because spending habits vary significantly between income groups. Here’s a breakdown:
- High-income households typically have a lower Marginal Propensity to Save (MPS). This means they spend a larger portion of their disposable income on consumption. They may have already met their basic needs and have more discretionary income for luxuries and experiences.
- Low-income households often have a higher Marginal Propensity to Save (MPS). They dedicate a larger portion of their income to essential needs like food and housing, leaving less for discretionary spending.
Demographic factors
Demographic factors like age, education, and family size significantly influence household consumption patterns. Consider these points:
- Age: Younger adults may spend more on entertainment, dining out, and establishing their households. Consumption patterns shift as people age, with a focus on necessities, healthcare, and potentially saving for retirement.
- Education: Higher education levels often correlate with higher incomes, potentially leading to increased spending on a wider range of goods and services.
- Family size: Larger families typically have higher consumption needs due to the increased demand for food, clothing, and housing.
Tastes and preferences
While challenging to quantify, tastes and preferences undeniably influence consumption patterns. These factors are driven by:
- Individual values: What people value most, such as experiences, luxury items, or practicality, will guide their spending decisions.
- Social influences: Trends, peer pressure, and societal expectations can shape how people choose to spend their money.
- Marketing and advertising: Companies use marketing strategies to influence consumer preferences and create brand loyalty.
Why is household consumption important?
Consumer behavior is the engine that powers economic activity. Consumption theory acts as our roadmap, helping us understand how individual spending decisions translate into real-world outcomes.
Key concepts like consumer surplus, decreasing marginal utility, and the law of demand illuminate how these choices influence the production of goods and services. Consumer surplus refers to the difference between the price a consumer is willing to pay for a good and the price they actually pay. Decreasing marginal utility explains the diminishing satisfaction gained from consuming additional units of a good.
Finally, the law of demand highlights the inverse relationship between price and quantity demanded – as prices rise, consumers tend to purchase less. By understanding these principles, we gain valuable insights into how individual choices regarding spending ultimately shape the production of goods and services within an economy.
Keynesian economics further underscores the critical role of consumption in driving economic health, particularly concerning income and employment. This theory posits that insufficient aggregate demand, the total spending on goods and services in an economy, leads to decreased production.
When production falls, businesses are compelled to reduce their workforce, resulting in unemployment. This rise in unemployment translates to a decline in overall disposable income, which in turn dampens consumption even further. This vicious cycle, if left unchecked, can spiral into a recession.
Keynesian economic theory emphasizes the importance of government intervention to stimulate aggregate demand through measures like fiscal policy and monetary policy, aiming to prevent such downturns.
The effect of household consumption on the business cycle
Household consumption expenditure contributes around 68% of the US Gross Domestic Product (GDP) in 2021. Consumption falls into three categories:
- Durable goods are tangible items with a useful life of more than three years
- Nondurable goods, such as food and beverages, are entirely consumed once.
- Services, which are the act of helping or doing work for another party.
Consumption spending can help understand fluctuations in the business cycle. During the economic recession phase, spending on durable goods decreases. They are expensive, and to buy them, households often borrow from banks. Therefore, during this period, they will postpone purchases until economic conditions improve.
As the economic recovery progresses, spending on durable goods increases. Because the price is relatively high, consumers will usually ponder carefully before buying.
When they see the economy will be better off in the future, they will buy it right away. Moreover, interest rates will usually remain low in this situation because the central bank is most likely to still keep interest rates low. The central bank will raise interest rates if the economy enters an expansion phase.
Hence, buying durable goods early in the economic recovery makes sense. Ultimately, the consumption of these durable goods will increase aggregate demand in the economy. That will stimulate businesses to increase output, bringing the economy into an expansionary phase.
