Concept, Determinants of consumption and its impact on other variables

Consumption is the value of goods and services bought by people. Individual buying acts are aggregated over time and space.

Consumption is normally the largest GDP component. Many persons judge the economic performance of their country mainly in terms of consumption level and dynamics.

Composition of Consumptions

First, consumption may be divided according to the durability of the purchased objects. In this vein, a broad classification separates durable goods (as cars and television sets) from non-durable goods (as food) and from services (as restaurant expenditure). These three categories often show different paths of growth.

Second, consumption is divided according to the needs it satisfies. A commonly used classification identifies ten chapters of expenditure:

1. Food

2. Clothing and foot wear

3. Housing

4. Heating and energy

5. Health

6. Transport

7. House furniture and appliances

8. Communication

9. Culture and schooling

10. Entertainment

People in different position in respect to income have systematically different structures of consumption. The rich spend more for each chapter in absolute terms, but they spend a lower percentage in income for food and other basic needs. The percentage values of an aggregation over all the households in a country can thus be used for judging income distribution and the development level of the society.

The rich have both higher levels of consumption and savings. In differentiated product markets, the rich can usually buy better goods than the poor. This happens also because they tend to use different decision making rules. In other words, consumption depends on social groups and their behaviours, as well as their proneness to advertising.

Third, for exactness’ sake, one should distinguish “consumption” as use of goods and services from “consumption expenditure” as buying acts. For durable goods this difference may be relevant, since they are sued for long time periods.

Fourth, only newly produced goods enter into the definition of consumption, whereas the purchase of, say, an old house is not considered consumption, since it was already counted in the GDP of the year in which it was built.

Determinants of Consumption

Current income is the most relevant determinant of consumption. Income comes from labour (employment and wages), capital (e.g. profits leading to dividends, rents, etc.), remittances from abroad.

Cumulated savings in the past can be squeezed in case of necessity and give rise to a jump in consumption, similarly with what happens with wealth increase, due for instance to stock exchange boom or house prices boom.

Expectations on future income, especially if concerning short-term credible events, may also play an important role.

At household level, there are many possible rules set to control monthly, weekly or even daily consumption expenditure. They relate not only to income but also to the following factors among others:

1. General lifestyles, in particular attitudes toward savings or consumption as “values” in itself;

2. A standard level of consumption the family tries to maintain over time;

3. Decisions regarding active saving strategies, like an investment scheme for pension aims;

3. The relative success of past investment in shares or other financial instruments; in fact, a stock-exchange boom is likely to promote an euphoria tide with growing consumption;

5. Opportunities of consumer credit, depending in turn by interest rates and marketing strategies by banks and special consumer credit institutions;

6. Past decisions on durables. For instance, a family having bought a car will reduce expenditure on public transport in favour e.g. of fuel;

7. Status symbols diffusion – “social musts”;

8. New employment perspectives, also as far as the corresponding investments in human and physical capital are concerned;

9. Innovative sale proposals in terms of both new products and new services, effectively advertised;

10. Temporary money (cash) excess.

According to age of the decision-maker, individual and household consumption varies, both in values and composition. Thus, aggregate consumption may be influenced by demographic factors, such as an older and older population, even though one should not rely too much on these relationships since demographic variables are extremely slow in changes, whereas consumptions clearly reacts to economic climate.

Other things equal, a higher price level (inflation) reduces the real current income, thus real consumption.

Impact on other variables

A GDP component as it is, consumption as an immediate impact on it. An increase of consumption raises GDP by the same amount, other things equal. Moreover, since current income (GDP) is an important determinant of consumption, the increase of income will be followed by a further rise in consumption: a positive feedback loop has been triggered between consumption and income.

An autonomous increase of consumption, if at the same level of income, would reduce savings, but the positive loop just described (known as the “Keynesian multiplier”) will imply an increase of income level with a positive impact on future savings.

If directed to goods and services produced abroad, an increase of consumption will immediately push up imports, while a similar indirect effect will result from consuming domestic products requiring foreign raw materials, energy, semi-manufactured goods.

Since usually the States separately tax consumption (say with a VAT tax), an increase of consumption will also boost this type of State revenue, as well as import duties revenue in the case of imported goods. The growth mechanism of consumption-income will also provide State revenue through income taxes.

To the extent firms decide to invest forecasting future demand and comparing it with present production capacity, an increase of consumption may induce new investment. In particular:

1. Soaring consumption raises the production capacity utilization, with positive effects on profits;

2. It improves expectations on future demand;

3. It improves the financial conditions for funding investment both through profits and loans.

If exports are a second-best solution for domestic firm, an increase of domestic consumption might decrease export, since at the same level of production firms would prefer to sell inside the country. To verify this by yourself, try and play “You are an exporter”.

An increased demand may also induce firms to increase prices, the more so when they operate at full production capacity or they operate on monopolized markets. Thus increased price level and accelerated inflation can be an effect of booming consumption.

Long-term trends

In Western countries, consumption has always grown in the last 50 years, except in few deep recessions. Its growth is smoother than investment’s rise or net exports’ growth. In particular, services have always systematically grown at a fairly steady pace, non-durables have often mirrored the business cycle and durables have often over-shot the fluctuations in GDP.

Business cycle behaviour

As the main component of GDP, it is pro-cyclical almost by definition: any large all in consumption would reduce GDP. Consumption has a smoother dynamics than GDP. During a recovery, it sustains and stabilises the trend. Durable goods are particularly cyclical and they may peak shortly before GDP.