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Chapter 5
THE HOUSEHOLD-CONSUMPTION SECTOR
Chapter 5
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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, Government Spending and Net
Exports are the four 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
5-3
Four Parts of GDP
 Consumption ------------ C

Consumption includes spending on consumer goods and services.
 Investment ---------------- I

Investment includes business investments in capital and inventories,
as well as residential investment by households.
 Government -------------- G

Government spending on goods and services.
 Net exports --------------- Xn

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 saving have increased slightly since
2007.


Consumers spend 67.7 percent of their disposable income on
services.
The rest is spent on durable goods, goods that last three
years or longer and nondurable goods, goods that last less
than three years.
5-5
Consumption Function
 A function specifies a relationship between two
variables.
 The Consumption Function states that
 As income rises, Consumption (C) rises, but not as quickly.
 Therefore, Consumption varies with Disposable Income (DI).
•
•
If DI increases then C increases but by a smaller amount.
If DI decreases then C decreases but by a smaller amount.
5-6
Example: Consumption and Disposable Income
(in billions of dollars)
Disposable
Income
1,000
Consumption
2,000
2,200
3,000
3,000
4,000
3,800
5,000
4,600
1,400
Note: C > DI at very
low income levels.
5-7
Consumption and Disposable Income
Disposable Income
Consumption
1,000
+ 1000
1,400
+ 800
2,000
+ 1000
2,200
+ 800
3,000
+ 1000
3,000
+ 800
4,000
+ 1000
3,800
+ 800
5,000
+ 1000
4,600
+ 800
Each time DI increases by $1,000, C increases by $800.
5-8
Saving
 Saving is defined as NOT spending.
 DI – C = S
 The more we spend, the less we save.
 A low saving rate leads to a low productivity growth
rate.

Without saving ($) to invest in NEW plant and equipment, we
cannot raise our productivity.
5-9
Saving as a Percentage of Disposable Income
5-10
Household Saving as a Percentage of
Disposable Income in 2012
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
Consumption and Saving
• Average Propensity to Consume: the percentage of
Disposable Income that is spent.
• Average Propensity to Save: the percentage of
Disposable Income that is saved.

APC + APS = 100% of DI or 1.00 in decimal form
• Marginal Propensity to Consume: the percentage of
an increase in Disposable Income that is spent

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 = 100% of DI or 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
 If APC = 1 all Disposable Income is consumed.
 If APC > 1 Consumption is more than Disposable
Income.
 If APC < 1 Consumption is less than Disposable
Income.
5-15
Sample APC Problem
Disposable Income
Consumption Saving
$40,000
$30,000
APC =
C
DI
30,000
=
40,000
$10,000
=
3
= .75
4
5-16
Sample APC Problem
Disposable Income
Consumption Saving
$40,000
$30,000
APC
APS
=
=
C
DI
30,000
=
40,000
S
DI
10,000
40,000
=
=
=
$10,000
3
= .75
4
1
= .25
4
5-17
Sample APC Problem
Disposable Income
Consumption Saving
$40,000
$30,000
APC =
C
DI
30,000
=
40,000
=
$10,000
3
4
= .75
+
APS =
S
DI
=
10,000
40,000
=
1
4
= .25
1.0
5-18
APCs Greater Than One
Disposable Income
Consumption
$10,000
$12,000
Saving
5-19
APCs Greater Than One
Disposable Income
$10,000
Consumption
$12,000
Saving
–$2,000
Where is this going to come from?
5-20
APCs Greater Than One
Disposable Income
Consumption
Saving
$10,000
$12,000
– $2,000
C
APC =
DI
$12,000
=
$10,000
12
=
10
= 1.2
5-21
APCs Greater Than One
Disposable Income
Consumption
Saving
$10,000
$12,000
–$2,000
C
$12,000
APC =
DI
= $10,000 =
10 = 1.2
APS =
S
DI
-$2,000
$10,000
-2
= –0.2
10
=
12
5-22
APCs Greater Than One
Disposable Income
Consumption
$10,000
$12,000
C
APC = DI
=
S
APS =
DI
$12,000
12
$10,000
= 10
-$2,000
=
$10,000 =
-2
10
Saving
– 2000
= 1.2
+
= –0.2
1.0
5-23
Average Propensity to Consume,
Selected Countries, 2012
5-24
Calculate MPC Using Hypothetical Data
Year
DI
C
S
2000
$30,000
$23,000
$7,000
2001
$40,000
$31,000
$9,000
5-25
MPC
Change in C = 31,000 – 23,000 = $8,000
Change in DI = 40,000 – 30,000 = $10,000
Change in C =8,000/10,000 = .8
Change in DI
The MPC is .8 or 80%
Therefore, 80% of the additional Disposable Income
is Consumed.
5-26
Calculating MPS
Change in S = 9,000 – 7,000 = $2,000
Change in DI = 40,000 - 30,000 = $10,000
Change in S = 2,000/10,000 = .2
Change in DI
• MPS = .2 or 20%
• Therefore, 20% if the additional Disposable Income
is Saved.
5-27
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 45-degree
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
5-28
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.
 Can you use these numbers to
calculate APC and MPC?
5-29
The Saving Function
 This graph uses the same
data as the Consumption
Function.
 S = DI  C.
 Can you calculate APS and
APC?
5-30
Autonomous Consumption vs. Induced
Consumption
 Autonomous Consumption
(AC) is the level of Consumption
when Disposable Income is “0”.


It is called autonomous because it
does NOT vary with the level of
Disposable Income.
AC = $2 trillion on graph
 Induced Consumption (IC) is
that part of Consumption that
does vary with the level of
Disposable Income.


As Disposable Income rises,
Induced Income rises.
As Disposable Income falls,
Induced Income falls.
 IC = C – AC for each level of DI
5-31
Questions for Thought and Discussion
 What does the 45-degree line represent? Discuss the
important features of the consumption function in
relation to this line.
 How many values for C and DI do you need to
calculate the APC? How many values for C and DI do
you need to calculate the MPC? Explain the difference.
 Why does the consumption function have a positive
slope?
5-32
Consumer Spending, 1955 and 2012
($billions)
The major change in consumer spending has been a
massive shift from nondurables to services.
5-33
Expenditures of the Average American
Household, 2011
5-34
Consumption as a Percentage of GDP
1980 - 2012
5-35
What Determines the Level of Consumption?
 Disposable Income
 The most important determinant of consumption.
 Credit Availability
 Ability to borrow affects spending.
 Decrease in home equity loans since 2006 has cut
Consumption.
 Stock of Liquid Assets in the hands of consumers
 Stocks, bonds, saving accounts, CDs, money market funds.
 Stock of Durable Goods in the hands of consumers
 Market saturation leads to drop in Consumption.
5-36
Determinants of the Level of Consumption
(continued)
 Keeping up with the Jones's.


Veblen’s theory of conspicuous consumption
Consuming things adds to our social status.
 Maintaining a basic standard of living



Social definition of basic standard of living changes over time.
The bar keeps rising.
Two-income trap.
 Consumer Expectations


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.
A fall in housing prices leads to falling Consumption.
5-37
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.

It seems there are quite a few deviations from the behavior
predicted by the permanent income hypothesis, why?
5-38
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.
•
Saving as Percentage of GDP, 1959-2012
5-39
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 saving has declined.
 Since Americans were not saving enough, we have needed
to borrow almost $2 billion a day from foreigners.
5-40
Economics in Action: The American Consumer:
World Class Shopper
 The consumer is the prime mover
of our economy and increasingly,
that of the world economy.
Private Consumption as a Percentage
of GDP, Selected Countries, 2008
 The American consumer made the
Japanese recovery possible after
World War II.
 The American consumer has
helped make 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.
5-41
Questions for Thought and Discussion
 What motivates consumption and on what do
Americans spend their money?
 How have American saving rates changed overtime?
What would be the consequences of present trends
continuing?
5-42