Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 5 THE HOUSEHOLD-CONSUMPTION SECTOR

5-2 Learning Objectives After this chapter, you should be able to: 1. Define and compute the average propensity to consume and the average propensity to save. 2. Define and compute the marginal propensity to consume and the marginal propensity to save. 3. Explain the consumption function. 4. Explain the savings function. 5. Calculate autonomous and induced consumption. 6. List and discuss the determinants of consumption. 7. Interpret and assess the permanent income hypothesis. 8. Explain why we spend so much and save so little.

5-3 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

5-4 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 X n  Exports minus imports.

5-5 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  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.

5-6 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.

5-7 Example: Consumption and Disposable Income (in billions of dollars) Note: C > DI at very low income levels.

5-8 Consumption and Disposable Income Each time DI increases by $1,000, C increases by $

5-9 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.

5-10 Saving as a Percentage of Disposable Income

5-11 Household Saving as a Percentage of Disposable Income in 2012

5-12 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?

5-13 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. Consumption and Saving

5-14 Average Propensity to Consume (APC) (The Percent of DI Spent) APC = Consumption Disposable Income

5-15 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.

5-16 Sample APC Problem Disposable Income Consumption Saving $40,000 $30,000 $10,000 APC = = = =.75 C 30,000 3 DI 40,000 4

5-17 Sample APC Problem Disposable Income Consumption Saving $40,000 $30,000 $10,000 APC = = = =.75 C 30,000 3 DI 40,000 4 APS = = = =.25 S 10,000 1 DI 40,000 4

5-18 Sample APC Problem Disposable Income Consumption Saving $40,000 $30,000 $10,000 APC = = = =.75 C 30,000 3 DI 40,000 4 APS = = = =.25 S 10,000 1 DI 40,

5-19 APCs Greater Than One Disposable IncomeConsumption Saving $10,000 $12,000

5-20 APCs Greater Than One Disposable IncomeConsumption Saving $10,000 $12,000 –$2,000 Where is this going to come from?

5-21 APCs Greater Than One Disposable IncomeConsumption Saving $10,000 $12,000 – $2,000 APC = = = = 1.2 C $12, DI $10,000 10

5-22 APCs Greater Than One Disposable IncomeConsumption Saving $10,000 $12,000 –$2,000 APC = = = = 1.2 C $12, DI $10, APS = = = –0.2 S -$2, DI $10,000 10

5-23 APCs Greater Than One Disposable IncomeConsumption Saving $10,000 $12,000 – 2000 APC = = = = 1.2 C $12, DI $10, APS = = = = –0.2 S -$2, DI $10,

5-24 Average Propensity to Consume, Selected Countries, 2012

5-25 Calculate MPC Using Hypothetical Data Year DI C S 2000 $30,000 $23,000 $7, $40,000 $31,000 $9,000

5-26 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.

5-27 Calculating MPS Change in S = 9,000 – 7,000 = $2,000 Change in DI = 40, ,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.

5-28 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

5-29 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?

5-30 The Saving Function This graph uses the same data as the Consumption Function. S = DI  C. Can you calculate APS and APC?

5-31 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

5-32 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?

5-33 The major change in consumer spending has been a massive shift from nondurables to services. Consumer Spending, 1955 and 2012 ($billions)

5-34 Expenditures of the Average American Household, 2011

5-35 Consumption as a Percentage of GDP

5-36 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.

5-37 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.

5-38 Permanent Income Hypothesis Idea proposed by Milton Friedman, a prominent conservative economist in the late 20 th 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?

5-39 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,

5-40 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.

5-41 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. 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. Private Consumption as a Percentage of GDP, Selected Countries, 2008

5-42 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?