The HouseholdConsumption Sector
Chapter 05
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives

After this chapter, you should be able to:
1.
2.
3.
4.
5.
6.
7.
8.
Define and compute the average propensity to consume and
the average propensity to save.
Define and compute the marginal propensity to consume and
the marginal propensity to save.
Explain the consumption function.
Explain the savings function.
Calculate autonomous and induced consumption.
List and discuss the determinants of consumption.
Interpret and assess the permanent income hypothesis.
Explain why we spend so much and save so little.
5-2
GDP and Big Numbers



Gross Domestic Product (GDP) is the nation’s
expenditure on all final goods and services produced
during the year at market prices.
Consumption, investment, and government spending
are the three main sectors of GDP.
GDP for 2009 was $14.2 trillion.
•
•
This can be written as
 $14,200,000,000,000
 $14,200 billion
 $14.2 trillion
Consumption by households was $10.089 trillion in 2009.
 10 trillion, 89 billion dollars
5-3
Four Parts of GDP

Consumption ------------ C (this chapter)
•

Investment ---------------- I (Chapter 6)
•

Investment includes business investments in capital and
inventories, as well as residential investment by households.
Government -------------- G (Chapter 7)
•

Consumption includes spending on consumer goods and
services.
Government spending on goods and services.
Net exports --------------- Xn (Chapter 8)
•
Exports minus imports.
5-4
Consumption

C is the largest sector of GDP.
•

C now accounts for 7 out of every 10 dollars spent on final goods
and services.
Americans spend virtually all of their income after taxes,
although savings have increased slightly since 2007.
•
•
Consumers spend 67.7 percent of their disposable income on
services such as medical care, gasoline, eating out, video
rentals, life insurance, and legal fees.
The rest is spent on durable goods, such as television sets and
furniture, or on nondurable goods, such as food and gasoline.
5-5
Consumption Function

A function specifies a relationship between two variables.
•
•

The consumption function states that
•
•

C varies with the level of after-tax income.
John Maynard Keynes noted that consumption was a stable
component of income.
As income rises, consumption (C) rises, but not as quickly.
Therefore, consumption varies with disposable income (DI).
 DI increases . . . C increases but by a smaller amount.
 DI decreases . . . C decreases but by a smaller amount.
We will look at the mathematical relationships behind this
function and then graph it.
5-6
Example: Consumption and Disposable
Income
(in billions of dollars)
Disposable Income
Consumption
1,000
1,400
2,000
2,200
3,000
3,000
4,000
3,800
5,000
4,600
Note that C > DI at
very low income
levels.
5-7
Consumption and Disposable Income
Disposable Income
Consumption
1,000
1,400
+ 1000
2,000
+ 1000
3,000
+ 800
2,200
3,000
+ 1000
4,000
5,000
+ 800
+ 1000
+ 1000
+ 800
3,800
4,600
+ 800
+ 800
Each time DI increases by $1,000, C increases by $800.
5-8
Saving

Saving is defined as NOT spending.
•
•

DI – C = S
The more we spend, the less we save.
A low savings rate leads to a low productivity growth
rate.
•
Without savings ($) to invest in NEW plant and equipment,
we cannot raise our productivity fast enough!
5-9
Saving as a Percentage of Disposable Income
Source: Economic Report of the President, 2010, Survey of Current Business, March 2010
5-10
Household Saving as a Percentage of Disposable
Income in 2009
Source: OECD
The U.S. saving rate is low compared with other developed economies.
5-11
Questions for Thought and Discussion

Americans spend more on services than on durable and
non-durable goods. Give an example of each category
from your own spending habits.

How is it possible to consume more than your income?

If a country has a negative saving rate, does that mean
that nobody in the country is saving?
5-12
Four Concepts


Average Propensity to Consume: the percentage of
disposable income that is spent
Average Propensity to Save: the percentage of
income that is saved
•

Marginal Propensity to Consume: the percentage of
an increase in disposable income that is spent
•

APC + APS = 100% of DI or 1.00 in decimal form
change in C divided by change in DI
Marginal Propensity to Save: the percentage of an
increase in disposable income that is saved
•
•
change in S divided by change in DI
MPC + MPS = 1.00 in decimal form
5-13
Average Propensity to Consume (APC)
(The Percent of DI Spent)
Consumption
APC =
Disposable Income
5-14
APC values and their meaning



The APC may = 1 signifying all disposable income is
consumed.
The APC may be > 1 signifying you are consuming
more than your disposable income by dipping into your
savings.
The APC may be < 1 indicating you’re a saving a
portion of your disposable income.
5-15
Sample APC Problem
Disposable Income
Consumption Saving
$40,000
$30,000
APC =
C
DI
30000
=
40000
$10,000
3
=
= .75
4
5-16
Sample APC Problem
Disposable Income
Consumption Saving
$40,000
$30,000
5-17
Sample APC Problem
Disposable Income
Consumption Saving
$40,000
$30,000
APC
APS
=
=
C
DI
30000
=
40000
S
DI
10000
40000
=
$10,000
=
3
= .75
4
=
1
= .25
4
5-18
Sample APC Problem
Disposable Income
Consumption Saving
$40,000
$30,000
APC =
C
DI
30000
=
40000
=
$10,000
3
4
= .75
+
APS =
S
DI
=
10000
40000
=
1
4
= .25
1.0
5-19
APCs Greater Than One
Disposable Income
$10,000
Consumption
Saving
$12,000
5-20
APCs Greater Than One
Disposable Income
$10,000
Consumption
$12,000
Saving
– 2000
Where is this going to come from?
5-21
APCs Greater Than One
Disposable Income
Consumption
$10,000
$12,000
C
APC =
DI
$12,000
=
$10,000
Saving
– 2000
12
=
10
= 1.2
5-22
APCs Greater Than One
Disposable Income
Consumption
$10,000
Saving
– 2000
$12,000
C
$12,000
APC =
DI
= $10,000 =
10 = 1.2
APS =
S
DI
-$2,000
$10,000
-2
= –0.2
10
=
12
5-23
APCs Greater Than One
Disposable Income
Consumption
$10,000
$12,000
C
APC = DI
APS =
$12,000
=
$10,000
Saving
– 2000
12
=
10
= 1.2
S
-$2,000
-2
+
DI
= $10,000
= 10
= –0.2
1.0
5-24
Average Propensity to Consume,
Selected Countries, 2009
Source: OECD
5-25
Marginal Propensity to Consume (MPC)
CHANGE in C
MPC
=
CHANGE in DI
5-26
Calculate MPC Using Hypothetical Data
Year
DI
C
S
2000
$30,000
$23,000
$7,000
2001
$40,000
$31,000
$9,000
5-27
Calculating MPC
Change in DI = 40,000 – 30,000 = $10,000
Change in C = 31,000 – 23,000 = $8,000
Change in C = 8,000/10,000 = .8
Change in DI
The MPC is .8
This country consumes 80% of each increase in disposable
income.
5-28
Calculating MPS
Change in DI = 40,000 - 30,000 = $10,000
Change in S = 9,000 – 7,000 = $2,000
Change in S = 2,000/10,000 = .2
Change in DI
MPS = .2
This country saves 20% of each increase in DI.
5-29
Graphing the Consumption Function: The
45- Degree Line






Notice that the scales of the
vertical and horizontal axes
are the same.
At each point along the 45degree line, the measurement
on the two axes is the same.
The line represents every
point where Expenditures
equal Disposable Income.
Example: On the 45-degree
line, when DI = 2,000, what
does Expenditures equal?
Answer: 2,000
Consumption is one category
of expenditures, so start by
graphing C.
5-30
Graphing the Consumption Function


Consumption is the vertical
distance between the
bottom (horizontal) axis and
the “C” line.
If DI = $3 trillion, how much is
C?
•
•



This is where the C function
crosses the 45-degree line.
C = DI = $3 trillion
If DI is $6 trillion, C will be
$4.5 trillion.
If DI is $1 trillion, C is $2
trillion. Some of the C is
financed by borrowing
(Example: Denmark).
Can you use these numbers
to calculate APC and MPC?
5-31
The Saving Function



This graph uses the same
data as the Consumption
Function.
S = DI  C.
Can you calculate APS and
APC?
5-32
Autonomous Consumption vs. Induced
Consumption

Autonomous consumption
(AC) is the level of
consumption when
disposable income is “0”.
•
It is called autonomous
because it is independent of
change in disposable
income.
• AC = $2 trillion on graph

Induced consumption (IC) is
that part of consumption that
varies with the level of
disposable income.
•
As disposable income rises,
induced income rises.
• As disposable income fall,
induced income falls.

IC = C – AC for each level of
DI
5-33
Questions for Thought and Discussion

What does the 45-degree line represent? Discuss the
important features of the consumption function in relation
to this line.

How many values for C and DI do you need to calculate
the APC? How many values for C and DI do you need to
calculate the MPC? Explain the difference.

Why does the consumption function have a positive
slope?
5-34
Consumer Spending, 1955 and 2009 ($billions)
The major change in consumer spending has been a
massive shift from nondurables to services.
Source: Survey of Current Business, 2010.
5-35
Expenditures of the Average American
Household, 2009 Bureau of Labor Statistics
Source: www.bea.gov
5-36
Consumption as a Percentage of GDP
1980 - 2010
Between 1982 and early 2008, there was a steady upward trend.
Source: www.bea.gov
5-37
Determinants of the Level of
Consumption
1.
Disposable Income
•
2.
Credit Availability
•
•
3.
Ability to borrow affects spending.
Decrease in home equity loans since 2006 has cut C.
Stock of Liquid Assets in the hands of consumers
•
4.
The most important determinant of consumption.
Stocks, bonds, savings accounts, CDs, money market funds
Stock of Durable Goods in the hands of consumers
•
Market saturation leads to drop in C.
5-38
Determinants of the Level of Consumption
(Continued)
5.
Keeping up with the Jones's
•
•
6.
Maintaining a basic standard of living
•
•
•
7.
Social definition of basic standard of living changes over time.
The bar keeps rising.
Two-income trap?
Consumer Expectations
•
•
8.
Veblen’s theory of conspicuous consumption
Consuming things adds to our social status.
Buy now if expect prices to rise.
Buy later if expect prices to fall in recession.
The Wealth Effect
•
•
When the value of your home or stocks increases, you feel
wealthier and spend more.
Fall in housing prices led to falling C.
5-39
Permanent Income Hypothesis


Idea proposed by Milton Friedman, a prominent
conservative economist in the late 20th century.
People gear their consumption to their expected lifetime
average earnings more than to their current income.
•
Apparently there are quite a few deviations from the behavior
predicted by the permanent income hypothesis.
5-40
Why Do We Spend So Much and Save So
Little?

Americans have been on a spending binge for the last
30 years.
•
•
Government policies encouraged consumption:
 Mortgage interest and property taxes are tax-deductable.
The tremendous expansion of bank credit cards, installment
credit, and consumer loans has further fueled the consumer
binge.
Savings as Percentage of GDP, 1959-2009
Source: Survey of Current Business, March 2010.
5-41
Why does it matter?


Every economy depends on saving for capital formation.
Individual saving + business saving + government saving
= Total Saving
•
•
•

Until the recession of 1981–82, as a nation we generally saved
about 20 percent of U.S. GDP.
Declines in household saving has been offset somewhat from
1993 – 2000 by a sharp rise in government saving and business
saving.
Since 2001, government savings have declined.
Since Americans were not saving enough, we have
needed to borrow almost $2 billion a day from foreigners.
5-42
Current Issue: The American Consumer:
World Class Shopper

The consumer is the prime
mover of our economy and
increasingly, that of the world
economy as well.

The American consumer made
the Japanese recovery
possible after World War II.

The American consumer has
made China’s economic growth
of about 10% over the last 20
years possible.

The negative aspect of this is
our tremendous trade deficits
with much of the rest of the
world.
Private Consumption as a Percentage
of GDP, Selected Countries, 2008
Sources: CEIC; OECD; World Bank.
5-43
Questions for Thought and Discussion

What motivates consumption and what do Americans
spend their money on?

How have American savings rates changed overtime?
What would be the consequences of present trends
continuing?
5-44