Saturday, 23 February 2013

Consumption : Food for Thought

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.

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. 

Helping the economy, bit by bit.

Consumption is about everyone!
Economics is for everyone!