What is Consumption?
What
did you eat today?
Which
movie did you watch last week?
How
many bus tickets did you purchase last month?
How
much electricity did you use last year?
All
these questions are common to us. We live in a world where we continuously
‘use’ things. We eat food, watch movies, travel buying bus tickets and consume
electricity. Economists call this Consumption. Consumption is the act of
utilization of things. Before we can understand consumption we must understand
what are these ‘things’. The formal term for these ‘things’ in economics is goods and services.
Goods
are objects or items such as cars, chocolates, footballs, pens, books, clothes
and everything that you see in your room right now. Services are provided to us
by other people. Doctors tell us how to be healthy, lawyers defend us in court,
night guards protect our homes and so on and so forth. Other people perform
acts for us; people ‘serve’ us in that sense. Goods and services never come
free as we have to pay for them. They are scarce
or limited and hence, we must
lose money to gain them. Consumption is also the outflow of money for these
goods and services.
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| This is Consumption. |
Consumption
is thus the way individuals like you and me use these goods and services. We ‘consume’
the scarce goods and services in order to live a happy life. If we do not
consume we will neither survive nor thrive. Consumption is extremely important
for all of us; we do it every moment of the day. We must also remember to note
the element of time. If we increase the time frame to a year from a month, we
will find that we have consumed more. The importance of Consumption becomes
visible when we understand the concept of Income.
Income is the inflow of money that every
person gets for the work he or she does. Laborers and factory workers are paid
daily, and that payment is called wages. Cooks and Economists, being better
off, are paid monthly and that payment is called salary. Both salaries and
wages are types of Income. What is important here is the element of time that
is involved. A laborer is paid by the day while an economist is paid by the
month. However, both of them get money over a period of time. Income is the
inflow of money over time.
Incomes
are used in two ways. One part is used
for consumption or the usage of goods and services from the economy. The other
part is saved. That is how
economists’ have explained Saving.
Saving is the leftover part of the income that people keep for later use. This division
of income into consumption and saving is
a fundamental fact of our lives. If Consumption is the part of the pie that you have eaten then Saving is the part of the pie that is left.
Income
= Consumption Expenditure + Savings
The Consumption Function
Apart
from separating income into consumption and saving, economists have tried to
find deeper relationships between the three. As you can see from your own life
also, different people with different levels of income have different
expenditure for consumption. Across generations, as incomes’ change for a
family, the pattern of consumption also changes. Apart from the simple separation
of consumption expenditure and saving that we read earlier, there exists another
direct relationship between
consumption and income. Consumption function is a mathematical formula to
obtain the level of consumption given a level of income. Economists tinker with
numbers to fit the consumption function for different countries and groups that
are being studied. J.M. Keynes, the famous American economist, emphasized this
relationship.
For instance
imagine a small country where all the consumption expenditure is only for carrots.
Bugs Bunny is a resident of this country and earns 10 units of currency every
month. He also spends a certain amount on carrots while the rest is saved for
later. If the consumption function for Bugs Bunny looks thus:
Consumption
Expenditure = 2 +
½ x Income
Then we can simply input Bugs Bunny’s income in the formula
and find out that he spends 7 units of currency on Consumption (carrots). We
also can see that he will save the rest i.e. 3 units of currency. The most
important feature of this formula is that it will tell us how much Bugs Bunny
will consume if he gets richer (higher income) or if he gets poorer (lower
income). We can easily input the value of income in the formula and obtain the
value for consumption.
Similarly,
the way we use this formula for one particular person (Bugs Bunny), we can also
use it for all the people. If we know the National
Income we can calculate the total
consumption expenditure of the entire nation. Although sometimes it is difficult
to figure out what exactly is consumption function, economists have used it on
many occasions.
Other Ideas on Consumption
After
the basic foundation of consumption
function there were many more ideas on consumption and saving. The most
important concepts are two- the ‘permanent income’ and the ‘life cycle’ idea.
Permanent Income Idea
This
theory suggests that people like to consume smoothly. This means that, people
don’t want to consume more in some years and less in some years. On a long time
scale, they want to maintain a similar
standard of living. While they are keen
to live better lives they certainly do not want to be worse off. It is because
of this feature that people do not trust ‘temporary income’ and rely more
on ‘permanent income’. Permanent income is that part of income that can be
expected to be regular. It is stable and does not increase or decrease
suddenly. Temporary income is that part of your income that you never expected.
For example, winning a lottery would be temporary income and earnings from a decade old farm gives you permanent income.
Because
people trust the permanent parts of income much more than the temporary parts
of their income, they base their consumption on it. So in other words,
consumption depends on the permanent part of people’s incomes, not on the
temporary part.
The Life Cycle Idea
The
life cycle idea brings finance into our understanding of consumption and
income. What it basically says is that even though we as individuals maintain a
similar standard of living throughout life, our incomes vary a lot. We do not
earn as children and as students. Neither do we earn when we are old and
retired. We earn the bulk of our life’s worth between the ages of 20 to 60. In
this middle age, we earn enough to provide for ourselves and manage to keep
some income for later use. What the Life Cycle Hypothesis says is that when we
are young and old our consumption expenditure exceeds our income and thus we
must borrow. In our middle ages as we earn more than we need for consumption,
we must save. Banks help us connect the phases of our life where we are in need
of money and when we have too much money.
The
life cycle hypothesis divides our lives into 3 parts.
1)
The Early Ages:
Between the ages of 0 to 20, we are mostly children and students who
need to borrow to maintain a standard of living. We are taken care of by family
and government. Our Consumption is more than our Income; hence we borrow to
maintain it.
2)
The Middle Ages: Between the ages of 20 to 60 we
are usually earning. We do not depend on anyone and earn much more than we can
consume. Hence our Income is more than our Consumption and we are able to pay
our past loans and save for the next age.
3)
The Old Ages: After 60, we are too old to work
and once again need looking after. We use the money that we have saved in the
Middle Ages, or in other words we dis-save in order to survive.
It’s all about us… really!
Consumption
and Saving, are concepts defined to explain what you and I do. These concepts
try to tell us how we spend and how we save. Economists spend years trying to
figure out how we as individuals spend our money. It’s all about us… really!
Economics in this case is once more trying to explain the very basic elements
of what we do. Economics is not rocket science or even ‘dismal science’. It is only
trying to help you understand yourself. Consumption is important both at
national and individual level. Good Governments are concerned to enable people
to raise their incomes and this ultimately leads to consumption spending. If we
are able to consume more, our standard of living rises. In my opinion, study of
Consumption can contribute to the welfare of
people. Also higher levels of Consumption gives more opportunity for business to bloom.
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| Helping the economy, bit by bit. |
Consumption
is about everyone!
