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Consumption (C)

a) The influence of disposable income on consumption

Consumption is spending by households on goods and services over a period of time and at a given price level (KEY DEFINITION).

There are a number of factors (that are discussed below) which have an influence on consumption, but the most significant of these is disposable income. In fact, John Maynard Keynes was the first to adamantly suggest this in his book 'The General Theory of Employment, Interest and Money'. Disposable income (Y) is the amount of money consumers have to spend after all required expenses are deducted, such as income and national insurance tax, mortgage payments, etc. It is the biggest influence on consumption simply because those with more disposable income will feel more inclined to spend it, increasing consumption.

In his book, Keynes also stated that whilst this is true, it depended on how much of this disposable income was saved. This calls into question the proportions of income which are saved and spent.

The average propensity to consume is the proportion of income that households spend.

APC = total consumption / total income

The marginal propensity to consume (MPC) is the proportion of extra income that households spend.

MPC = change in consumption / change in income

The average propensity to save is the proportion of income that households save.

APS = total saving / total income

The marginal propensity to save (MPS) is the proportion of extra income that households save.

MPS = change in saving / change in income

For most, the MPC will be between 1 and 0, as they will spend some of their extra disposable income, but also save some as well. Some will have an MPC higher than 1 if they use borrowing or savings to increase their spending above their level of additional income. For an economy overall, the APC is almost always between 1 and 0 as people save some of their money.

b) Relationship between saving and consumption

Savings is what is not spent via consumption from disposable income. Because savings and consumption are in essence opposites, any factor which influences consumption in one way will affect savings in the other. Here are the main factors which influence savings:

Future commitments - This may be saving for a holiday, wedding, etc. I am currently saving for a holiday to France next year with my friends (an example of a future commitment).

Life cycle reasons - From ages 0-18, the majority of income you receive you will spend, as you are financially supported by your parents. However, from after adolescence and until you retire you will save more to prepare a pension for retirement.

Interest rates - If interest rates are higher, there is a greater incentive to save as you will receive more of a reward for saving.

Precautionary reasons - In a recession people are likely to save more incase they need money in time of emergency, for example if they are laid off they will need money to support their family.

Use the word FLIP as a mnemonic device for remembering the factors which influence savings!

c) Other influences of consumption

Asset prices - Wealth refers to the stock of assets, and those who experience an increase in the value of their wealth tend to then consume more. This is known as the wealth effect. This may be experienced as house prices rise, meaning that consumers feel more well off and are likely to spend more because they feel as though they have more money when in reality it is tied up in their assets. The same can happen with stocks and shares, whereby if they appreciate the owner of them may spend more for the same reasons as above. A positive wealth affect leads to more consumption.

Disposable income - As discussed above, if consumers have more disposable income, they will spend more.

Debt availability - If it is easier to borrow in an economy, then more are likely to take out loans. This will increase disposable income beyond the input of wages, and if consumption rises significantly then the MPC may rise above 1. The high reliance on mortgages in the UK for house ownership has allowed for less income to be spent on housing in the short term, freeing up more disposable income (of course in the long run there will be a higher cost due to interest on the debt). Because of this, the UK is a debt fuelled economy, and this was the biggest driver of economic growth in the UK from 1997-2007.

Interest rates - If interest rates are higher, there is a greater incentive to save as you will receive more of a reward for saving, and therefore the MPC will drop, lowering consumption. 

Confidence - If consumers are confident in the economy, and feel that the likelihood of recession is low, then they will spend more and save less as there is no reason to take precautions.

Tastes - Especially in Western society, there is the presence of materialism. This drives people to purchase the newest, best and trendiest goods and services, increasing consumption.

Use the word ADDICT as a mnemonic device for remembering the factors which influence consumption!

To help revise this, click the button for my condensed flashcards!

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