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What Is Consumption

Consumption refers to the use of goods and services by households and is a key component in calculating GDP. It is also important for business valuation and economic modeling as it represents overall economic activity. Consumption is the start and end of all economic activities, as production is dependent on consumption to drive demand. Various economic theories around demand, utility, government policies, income, employment, and the business cycle are based on analyzing consumption trends and behaviors.

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Bhumika Chaudhary
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132 views

What Is Consumption

Consumption refers to the use of goods and services by households and is a key component in calculating GDP. It is also important for business valuation and economic modeling as it represents overall economic activity. Consumption is the start and end of all economic activities, as production is dependent on consumption to drive demand. Various economic theories around demand, utility, government policies, income, employment, and the business cycle are based on analyzing consumption trends and behaviors.

Uploaded by

Bhumika Chaudhary
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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What is Consumption?

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.

When valuing a business, a financial analyst would look at the consumption trends in the business’ industry. It is an important
step, as it helps the analyst with the assumption section of the financial model. 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.

Consumption Cycle
Consumption and the Business Cycle

Consumption expenditure in the private sector accounts for two-thirds of the Gross Domestic Product (GDP). The
remaining one-third consists of government expenditure and net exports. Private consumption is divided into three
categories: Durable goods that are defined as goods with a lifetime greater than three years, services that include
travel and car repairs, and non-durable goods such as food and water that can be immediately consumed.

The consumption flow and expenditure (consumption expenditure) can help analysts understand the fluctuations in
the business cycle. Producers of durable goods only earn income from the sale of the initial product (expenditure),
not from consuming the goods following the purchase.

Hence, it is expenditure and not consumption flow that determines short-term economic prosperity. Due to the
nature of durable goods, economists have created a rational optimization framework to account for the goods.
During an economic downturn, consuming durable goods decreases because the goods require a significant
investment, and consumers will put off the purchases until economic conditions improve.

When the economy recovers, spending on durable goods increases and becomes more volatile than spending on
non-durable goods. A change in interest rates, tax rates, or other stimulus measures affects spending on durables
more than any other kind of spending.

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