Chapter 5-- The Household-Consumption Sector

Remember when we discussed the Circular Flow Model in the last chapter, we talked about how households (persons or groups of persons living under one roof) trade their land, labor, capital, and entrepreneurial abilities for money-- rents, wages & salaries, interest, and profits. Well, almost all of the money (after taxes) winds up flowing back to the business sector of our economy. That is, consumers spend it on the goods and services supplied by businesses. In this chapter, we take a closer look at this consumption-- what we spend, and what determines how much we spend.

1. Gross Domestic Product (GDP)
1. Think of it as a machine:
1. You feed it land, labor, capital, and entrepreneurship.
2. It ultimately gives you goods and services.
3. That's GDP.



2. More precisely, GDP is what business and government does with the resources we provide them.
1. The combined final (retail) value of all goods and services created on American soil.
2. Even the resources of foreign nationals working and living on American soil is counted as GDP.



3. Perhaps you've heard of something similar-- Gross National Product (GNP).
1. GNP is the final value of all goods and services produced from American land, labor, capital, and entrepreneurship, wherever in the world that may be.
1. A lot of American citizens live and work abroad. Their resources are used to calculate our GNP.
2. Likewise, a lot of American-owned companies operate in countries all over the world. Their output is GNP, however, it is not GNP.



2. Consumption
1. I once heard a quote: "The average is American is about average, by all estimates."



2. If the combined disposable income (income after taxes) of Americans is about $7,500 Billion ($7.5 Trillion), and we spend about $7,125 of it, we are consuming 95% of our incomes.
1. C / DI = 95%



3. Let's use a term to describe this situation. After all, it sounds too simple. So we'll give it a name like:
1. THE AVERAGE PROPENSITY TO CONSUME (APC)
1. APC = C / DI
4. Consumer spending makes up about two thirds of GDP. Investment and government spending complete the picture. More on those in the next two chapters.



5. What do we buy?
1. Services
1. Medical care, education, dining out, theater tickets, insurance, etc.
2. Durable goods
1. Appliances, cars, hardware, furniture-- in short, stuff that lasts for more than a year.
3. Non-durable goods
1. Food, fuel, supplies-- stuff that is used up quickly.



4. Services used to consume only 36 cents of every dollar spent. Now they consume about 59 cents of the dollars spent.
1. One big reason for the difference: healthcare costs.
2. Another: more Americans dine out than ever before.
3. And in general, we tend to hire people to do things we used to do ourselves.



6. The Consumption Function
1. Keynes said that as peoples' income rises, so does their consumption spending-- but, not as fast.
1. Think about it, if you hit the lottery, you probably would save a greater portion of your income than you do now. Yes, your consumption spending would probably rise to new heights (I know mine would-- cars, homes, gadgets) But you are a sensible person, right? And you would likely save a good bit, too!
1. Those of you who would end up actually worse off can always go on Sally Jessy Rafael when she does the show on idiots who blew their lottery fortunes.



2. It's called the Consumption Function because economists like to draw lines on graphs a lot. A function is a line-- a mathematical relationship between two things. In this case, we're looking at how consumption relates to disposable income at various points.



7. Saving
1. Saving is simply, not spending. There are only two possibilities. Your after-tax income is either spent or saved.
2. We used to save a lot more. Other cultures have traditionally outsaved us, too. We can debate the reasons for hours. ( So, if we need to kill some time in class, we'll debate it.)
3. Economists (you guessed it) also have a fancy term for how much we save.
1. Average Propensity to Save = Savings / Disposable Income
2. Another way to put it: APS = 1 - APC
4. As disposable income increases, APC decreases, and APS increases.



8. The Marginal Propensity to Consume (MPC)
1. Whenever in your studies of business you hear the word "marginal," think of the word "extra."



2. A marginal increase means a small increase-- more precisely, what would happen if consumers had one extra dollar of disposable income? How much of it would be consumed or saved?
3. That's the MPC, figured like this:

Change in Consumption / Change in Disposable Income

1. So, if a society's disposable income increases by $1,000 (billion), and its consumption increases by $900 (billion), the MPC = 9/10, or 90%.



2. The MPC is the slope of the consumption function.



3. Of course, MPC has an economic counterpart, the MPS (Marginal Propensity to Save), figured simply as 1 - MPC = MPS.



1. Autonomous and Induced Consumption
1. If disposable income were ZERO, note from the graphs we have seen (especially Fig. 4 on page 91) that consumption is NOT zero.
1. This is reasonable. Even if we have no money, we still find a way to get certain necessities-- beg, steal, or borrow.
2. This level of consumption has nothing to do with disposable income.
3. You could say it happens independently or regardless of disposable income.



2. Another word for this independence is autonomous.



3. At low levels of income, we have autonomous consumption.
1. Think of it as a floor-- consumption will never fall below that certain level.



4. And we already know that as disposable income is increased, we are usually induced to consume more, right?



5. This consumption that results from getting more disposable income is called induced consumption. It's just that simple.

1. What the Consumer Buys
1. Quite simply, we buy goods and services-- about $6,000 Billion (6 Trillion) worth a year, and climbing.
1. Goods are classified as
1. Durable goods-- cars, furniture, appliances-- things that last.
2. Non-durable goods-- food, supplies, fuel-- things that don't last.



2. Services eat up about 60 cents on the dollar, compared with about 36 cents a half a century ago.
1. There are many reasons for that including cultural and economic changes.
1. We often pay others to do what we used to do ourselves (specialization).
2. We have come to depend on services more heavily, and as such, supply and demand has forced up the price of those services, like healthcare.



3. Interestingly, when we prepare a meal at home, for example, the meal and its "components"-- meat, potatoes, vegetables-- are figured into GDP as non-durable goods.



4. However, that same meal prepared and served to us in a restaurant figures into GDP as services.



2. Deciding Factors (determinants) of How Much We Spend
1. DI
2. How much credit we can get
1. If auto dealers will let us drive it off the lot with no money down, we might buy it without that much consideration, right?
3. How much cash we have at our disposal-- usually savings.
4. How much stuff (durable) we already own-- do we feel we have enough?
1. Market saturation-- sales of things like VCR's and TV's have leveled off since most people own them.
5. What our neighbors (the Joneses) have.
1. A false sense of "self worth" often is affected by what others around us own. If my neighbor gets a new car, well, maybe I should too!
1. See, economics is really all about human behavior, isn't it?
6. Our expectations of future economic conditions.
1. If we think lean times are ahead, we may be reluctant to step into a major purchase, right?



2. The Permanent Income Hypothesis
1. Milton Friedman-- Nobel Prize winning economist has a belief that peoples' spending reflects their expected earnings, not necessarily their current incomes.
1. In other words, if you expect to be a CEO of a Fortune 500 company someday, you may tend to spend like you already are one.



2. Likewise, if you see yourself flipping burgers at age 62, you may be a little more conservative in your spending, generally.



2. Do you buy that?
1. I'm not sure I do. Like many other Americans, I have gone through a number of career/job changes over the years-- and many of you can expect to do the same.



2. If there ever was any loyalty between companies and their people, most of it is gone. Companies care about the bottom line. Whatever they do, net earnings, and thus, shareholder wealth is the ultimate concern. And, of course, who can really argue with that?



3. So, as far as a permanent income hypothesis is concerned, how many of us have an idea of where we may be and what we will earn in 20 years from now?
1. A few of us? Yes, but many among us just don't know.



4. In fact, our author points out that we are spending like there's no tomorrow. That notion implies that we have no idea what our future incomes are going to be-- or maybe, since we're spending so much, we must believe we'll all be CEO's someday!



3. Spending So Much, Saving So Little
1. Two factors that have influenced our behavior of consuming more and saving less during the 20^th century:
1. The existence of Social Security
2. The ability to buy a home



2. Social Security
1. Our author contends that many people don't save for retirement because they believe Social Security will provide a sufficient income in their silver years.
1. While most of us are a bit skeptical about SS, this theory makes some sense.



3. Increased home ownership
1. How many of you own a home? Do your parents own a home?



2. When economists cry that people just aren't saving enough because they're busy paying their mortgages, don't you just want to smack them?

1. Hey Milton, owning a home is saving! It might even be the best savings vehicle anyone could ever have!



2. The author points out that in 1949, heads-of -households spent (or, should we say invested) about 14 percent of their incomes on making the mortgage payments.



3. By 1997, the mortgage payment averaged 40% of one's disposable income.
1. Why do you suppose?
1. Standards have changed-- we demand bigger and better homes than ever?
2. Homes cost a lot more than they used to-- no wonder we're spending (er . . . investing) so much more!



4. Yes, homes cost a lot more. But is there a silver lining here?
1. Yes, again. Rising prices in the real estate market mean that we have a seller's market.



2. If you or your parents were fortunate enough to have owned a home for a few years, you can take comfort in the fact that the value of your investment has substantially increased! Yeah baby, yeah!



3. Economists often sympathetic to the business sector (didn't we used to call them republicans?) complain about our poor saving habits. But with home ownership, WE ARE INVESTORS-- we just invest in ourselves, not in Exxon, AOL/Time-Warner, and AT&T.



1. If we are spending, and many companies are reporting record earnings, what's the problem?
1. Economists claim that we don't save enough. They say businesses have to rely more and more on foreign investment to survive.



2. Gee, if we're buying stuff and companies are profiting, why don't they just reinvest their profits?



3. Think about it, whether we feed companies capital to operate, or if they just accumulate their net earnings, what's the difference.
1. Sure, start ups and expanding companies each need a capital injection, but after they're up and running, shouldn't they be able to sustain their operations with their earnings? Wouldn't that be efficient, not to mention, responsible?



4. And what's wrong with foreign investment? Perhaps we are becoming a global society, and the differences between us will eventually fade. Then it will all be domestic investment!