MANAGERIAL ECONOMICS-CHAPTER 6-THE THEORY OF CONSUMPTION

Theory of Consumption in Economics

Consumption in economics is the foundation of numerous theories. Since
economic activity is essentially rooted in consumption, many economic theorists
have developed conceptualizations about its role in economies. Economic
philosopher, John Maynard Keynes, founded a wide range of theories that all
have ties (limited or substantial) to consumer spending and consumption. The
main theme of Keynesian economics is the notion that individuals must spend as
much of their real income as possible. He supports this statement with an
argument in favor of the general economy. When consumers spend the majority
of their real income, they maximize their consumption, increasing economic
activity. As a result, businesses growth and the economy expand. However, it is
important to note that unsustainable economic expansion is normally
accompanied by heated inflation, which essentially calls for consumption to be
regulated.
The term consumption function refers to an economic formula that represents
the functional relationship between total consumption and gross national income
(GNI). The consumption function was introduced by British economist John
Maynard Keynes, who argued the function could be used to track and predict
total aggregate consumption expenditures. It is a valuable tool that can be used
by economists and other leaders to understand the economic cycle and help them
make key decisions about investments as well as monetary and fiscal policy.
Consumption is defined as the use of goods and services by a household. It is a
component in the calculation of the Gross Domestic Product (GDP).
Macroeconomists typically use consumption as a proxy of the overall economy.

FACTORS OF CONSUMPTION
Consumption factors are as follows.
#1 – Family Size
When studying a regular household, family size denotes the number of
purchases a family makes for utilities, resources, and different types of goods
and services. The larger the family, the larger the purchase.
#2 – Age
When we compare a single product, age becomes critical. This is because many
products specifically target a section of a population and, in most cases, a
specific age bracket. Even otherwise, growing children consume more than
average quantities of food. Similarly, an old or weak person might consume less
than a regular person.
#3 – Education
Education constitutes the psychological factor that impacts buying behaviors.
An educated person is expected to have a comparatively rational approach
toward the purchase—they are more likely to put needs ahead of wants. Also,
intellectual pursuits create demand for specific products and services—books,
podcasts, nebula, curiosity stream subscriptions, etc.
#4 – Employment
An employed person is more likely to budget their purchase. On the other hand,
an unemployed person has lesser purchasing power. During an economic
recession, overall market demand decreases. Economic growth is the polar
opposite—employee wages rise—demand and sales rise.

#5 – Interest Rates
Interest rates regulate capital markets—influence banks and financial products.
If interest rates are high, people may not invest in a new home. They cannot
afford credit cards or loans.
ANOTHER SET OF DETERMINANTS OF CONSUMPTION
Determinant factors of consumption
The main factors affecting consumption studied by economists include:

● Income: Economists consider the income level to be the most crucial

factor affecting consumption. Therefore, the offered consumption
functions often emphasize this variable. Keynes considers absolute
income,[24] Dosnbery considers relative income,[25] and Friedman
considers permanent income as factors that determine one's
consumption.[26]
● Consumer expectations: Changes in the prices would change the real
income and purchasing power of the consumer. If the consumer's
expectations about future prices change, it can change his consumption
decisions in the present period.
● Consumer assets and wealth: These refer to assets in the form of cash,
bank deposits, securities, as well as physical assets such as stocks of
durable goods or real estate such as houses, land, etc. These factors can
affect consumption; if the mentioned assets are sufficiently liquid, they
will remain in reserve and can be used in emergencies.
● Consumer credits: The increase in the consumer's credit and his credit
transactions can allow the consumer to use his future income at present.
As a result, it can lead to more consumption expenditure compared to the
case that the only purchasing power is current income.
 ● Interest rate: Fluctuations in interest rates can affect household
consumption decisions. An increase in interest rates increases people's
savings and, as a result, reduces their consumption expenditures.
● Household size: Households' absolute consumption costs increase as the
number of family members increases. Although for some goods, as the
number of households increases, the consumption of such goods would
increase relatively less than the number of households. This happens due
to the phenomena of the economy of scale.
● Social groups: Household consumption varies in different social groups.
For example, the consumption pattern of employers is different from the
consumption pattern of workers. The smaller the gap between groups in a
society, the more homogeneous consumption pattern within the society.
● Consumer taste: One of the important factors in shaping the consumption
pattern is consumer taste. This factor, to some extent, can affect other
factors such as income and price levels. On the other hand, society's
culture has a significant impact on shaping the tastes of consumers.
● Area: Consumption patterns are different in different geographical
regions. For example, this pattern differs from urban and rural areas,
crowded and sparsely populated areas, economically active and inactive
areas, etc
Types of Consumption in Economics

● Direct Consumption

When the commodities consumed are for human want and they are consumed
directly, it is called direct consumption. Examples include foods and beverages,
toys, etc.

● Productive Consumption

When a commodity is consumed in the production of another product, such

consumption is known as productive consumption.
For example, the use of soda for the production of soaps. Productive
consumption is also called indirect consumption.

● Slow Consumption

The type of consumption of commodities that remain effective for a long period
of time is known as slow consumption.
For example, the use of consumer durables, electronics, etc., falls in this
category.
The consumption of commodities that last only for a moment is called quick
consumption.
For example, consumption of single-use goods, such as tea, and coffee falls in
this category.

● Wasteful Consumption

The consumption of commodities that lead to the creation of waste or useless

items is known as wasteful consumption.
Examples include the use of mirrors that break down due to mishandling.
How do Income, Prices, and Preferences Affect Consumer Choices?

● Income –

The budget constraints effects in consumer choices are usually expressed with
two products on the vertical and horizontal axes. Depending on the rise of the
income usually, an increase in consumption of both goods is observed in a
comparison budget line of two products. Similarly, a drop in income leads to a
drop in consumption of both goods. Goods and services that show such trends
are known as normal goods.
In the case of inferior goods, however, people trim the expenditure on goods
and services they availed previously with an increase in incomes. Such behavior
is observed because, with a higher income, people can opt for costlier products.
 ● Price − Usually, an increase in prices leads to the consumption of one or
both goods in the case of normal goods. There are two effects that are
mainly responsible for this. The substitution effect occurs when people
buy less of the product the price of which has increased and more of that
the price of which hasn’t. The income effect takes place when the
purchasing capability of the buyer goes down which leads to a cut in the
buying behavior of both the items.
● Preferences − According to the completeness assumption of preferences,
the buyers will tend to buy products they like irrespective of income and
price factors. The consumer is usually capable to say which of the two
items he prefers more.
The assumption of non-satiation on the other hand relies on the fact that more
of any good is better until it affects the consumer’s capability to utilize all other
services or goods.
Importance of Consumption
Modern economists give a lot of importance to the level of consumption in the
economy because it characterizes the economic system the country currently
operates in.
1. The beginning of all economic activity
Consumption is the start of all human economic activity. If a person desires
something, he will take action to satisfy this desire. The result of such an effort is
consumption, which also means the satisfaction of human wants.
2. End of economic activities
If, for example, a person desires a sandwich, they will take the effort to make the
sandwich. Once it is made, the food is consumed, resulting in the end of an
economic activity.

3. Consumption drives production

According to economist Adam Smith, “Consumption is the sole purpose of all
production.” It means that the production of goods and services is dependent on
the level of consumption.
4. Economic theories
The study of consumption theory has helped economists formulate numerous
theories such as the Law of Demand, the Consumer Surplus concept, and the Law
of Diminishing Marginal Utility. These theories help analysts understand how
individual behavior affects the input and output in the economy.
5. Government theories
Consumption habits also help the government formulate theories. The minimum
wage rate and tax rate are determined based on the habits of individuals. It also
helps the government make decisions on the production of essential and non-
essential commodities in a country. It also provides the government with insight
into the saving to spending ratio in the economy.
6. Income and employment theory
Consumption plays an important role in the income and employment theory
under Keynesian economics as put forth by John Maynard Keynes. Keynesian
theory states that if consuming goods and services does not increase the demand
for such goods and services, it leads to a fall in production. A decrease in
production means businesses will lay off workers, resulting in unemployment.
Consumption thus helps determine the income and output in an economy.

Why We Buy What We Buy: A Theory of Consumption Values

Three fundamental propositions are axiomatic to the theory:
1. Consumer choice is a function of multiple consumption values.
2. The consumption values make differential contributions in any given choice
situation.
3. The consumption values are independent.
What Is a Consumption Tax?

● A consumption tax is a tax on the purchase of a good or service.

Consumption taxes can take the form of sales taxes, tariffs, excise, and
other taxes on consumed goods and services.
● A consumption tax can also refer to a taxing system as a whole in which
people are taxed based on how much they consume rather than how much
they add to the economy (income tax).
● Taxes on goods and services are commonly referred to as consumption
taxes.
● Retail sales tax and value-added tax are examples of a consumption tax.

● A consumption tax is charged when consumers spend money, while an

income tax is assessed on earned money.
Common Types of Consumption Taxes

● Value-Added Tax

Most countries have a consumption tax system in the form of VATs, or value-
added taxes.
A VAT is a tax on the difference between what a producer pays for raw materials
and labor and what the producer charges for finished goods. Hence this
consumption tax is levied on the “value added” to goods and services from the
production stage to the final consumption stage.

● Excise Tax

An excise tax is a sales tax that applies to a specific class of goods, typically
alcohol, tobacco, gasoline, or tourism. Some excise taxes are charged to
discourage a behavior or purchase of certain goods that are thought to be
detrimental to the economy. These excise taxes are more commonly known as sin
taxes. Other excise taxes are applied to people who benefit from a program or
infrastructure. For example, taxes on gasoline are collected from drivers to
maintain roads, highways,

● Import Duties

Import duties are taxes levied on an importer for goods entering the country. The
taxes are passed on by the importer to final consumers through higher costs. The
amount of this consumption tax payable varies greatly depending on the
imported good, the country of origin, and several other factors. Import duties can
be calculated as a percentage of the value of the goods being imported, or based
on the quantity, weight, or volume of the goods being imported.