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 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 this 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. Therefore, 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 factors 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, the Consumer Surplus concept, and the
Law of Diminishing Marginal Utility. These theories help analysts 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 as put forth by John Maynard Keynes. Keynesian
theory states that if consuming goods and services does not increase the
demand for such goods and services, it leads to a fall in production. A
decrease in production means businesses will lay off workers, resulting in
unemployment. Consumption thus helps determine the income and output in
an economy.

 
 

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 consists of
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

analysts 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 goods 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. A change in
interest rates, tax rates, or other stimulus measures affects spending on
durables more than any other kind of spending