Chapter 4

Chapter 4

The Household-Consumption Sector

5-1
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GDP and Big Numbers

Gross Domestic Product (GDP) is the nations

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.

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 Four Parts of GDP
Consumption ------------ C
Consumption includes spending on consumer goods
and services.
C is the largest sector of GDP.
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.

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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. 5-4
Example: Consumption and Disposable Income
(in billions of dollars)

Disposable Consumption
Income
1,000 1,400
Note: C > DI at very
low income levels.
2,000 2,200
3,000 3,000
4,000 3,800
5,000 4,600

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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.

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 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.

5-7
 City A City B

income Consumption income Consumption

25,000 2,500 25,000 1,250

30,000 3,000 30,000 1,500

35,000 3,500 35,000 1,750 5-8

 Economic Theory
A statement or set of related statements about cause
and effect, action and reaction.
Example price goes up quantity goes down law of
demand
Model
A formal statement of a theory, usually a
mathematical statement of a presumed
relationship between two or more variables.

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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

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Average Propensity to Consume (APC)
(The Percent of DI Spent)

Consumption
APC =
Disposable Income

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Average Propensity to Save (APS)

Saving
APC =
Disposable Income

5-12
Sample APC Problem

Disposable Income Consumption Saving

$40,000 $30,000 $10,000

C 30,000 3
APC = = = = .75
DI 40,000 4

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Sample APC Problem
Disposable Income Consumption Saving
$40,000 $30,000 $10,000

C 30,000 3
APC = = = = .75
DI 40,000 4

S 10,000 1
APS = = = = .25
DI 40,000 4

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Sample APC Problem
Disposable Income Consumption Saving
$40,000 $30,000 $10,000
C 30,000 3
APC = = = = .75
DI 40,000 4
+
S 10,000 1
APS = = = = .25
DI 40,000 4
1.0

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APCs Greater Than One

Disposable Income Consumption Saving

$10,000 $12,000

5-16
APCs Greater Than One

Disposable Income Consumption Saving

$10,000 $12,000 $2,000

Where is this going to come from?

5-17
APCs Greater Than One
Disposable Income Consumption Saving
$10,000 $12,000 $2,000

C $12,000 12
APC = = = = 1.2
DI $10,000 10

5-18
APCs Greater Than One
Disposable Income Consumption Saving
$10,000 $12,000 $2,000

C $12,000 12
APC = DI = $10,000 = 10 = 1.2

S -$2,000 -2
APS = = = 0.2
DI $10,000 10

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APCs Greater Than One
Disposable Income Consumption Saving
$10,000 $12,000 2000
C $12,000 12
APC = DI = $10,000 = 10 = 1.2

S -$2,000 -2 +
APS = DI = $10,000 = 10 = 0.2
1.0

5-20
Calculate APC and APS Using Hypothetical
Data

Year DI C S
2000 $30,000 $23,000 $7,000
2001 $40,000 $31,000 $9,000

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 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.

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 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. 5-23
Calculate MPC Using Hypothetical Data

Year DI C S
2000 $30,000 $23,000 $7,000
2001 $40,000 $31,000 $9,000

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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.

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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.
MPC + MPS = 100% of DI or 1.00 in
decimal form. 5-26
 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.

5-27
Graphing the Consumption Function: The 45-Degree
Line
Notice that the scales of the
vertical and horizontal axes
are the same.
APC = 1 all
At each point along the 45-
Disposable Income
degree line, the measurement
on the two axes is the same.
Theislineconsumed
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

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5-29
 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?
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 The Saving Function
As income rises, saving rises, but not as quickly.
The basic relationships: Disposable income=Consumption + Saving
Draw The Saving Schedule

Disposable income Consumptio Saving

n
9 millions 6 millions
7 millions 5 millions
5 millions 4 millions
3 millions 3 millions
1 millions 2 millions
Negative saving is known as dissaving 5-31
The Saving Function

This graph uses

the same data
as the
Consumption
Function.
S = DI C.
Can you
calculate
APS and
APC?
5-32
 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. 5-33
 Autonomous Consumption vs. Induced Consumption

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

Consumption=Autonomous consumption + Induced

consumption 5-34
The three categories of consumption for
individuals
1. Durable: last a while at least three years
2. Non durable : dont last long
3. Service : education, medical , legal,
financial services

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 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?

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 What Determines the Level of Consumption?
Disposable Income
The most important determinant of
consumption.
Credit Availability
Ability to borrow affects spending.
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.
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Determinants of the Level of Consumption (continued)
Keeping up with the Jones's.
Veblens 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.
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. 5-38
Why does it matter?

Every economy depends on saving for capital formation.

Individual saving + business saving + government saving =
Total Saving
Until the recession of 198182, 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.

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1. Calculate the APS and
APC when disposable
income 6 trillions and 8
trillions
2. What is the autonomous
consumption?
3. What is the induced
consumption when
disposable income is 4
and 8 trillions.
4. Draw the saving schedule
figure.

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