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.

Consumption in Neoclassical Economics

Neoclassical economists view consumption as the final purpose of an economic activity,

hence, the per person value is an important factor in determining the productive
success in an economy.

Macroeconomists use this economic measure for two reasons. The first is to assess
aggregate savings in each household; savings refer to the portion of income that is not
used for consuming goods and services. Aggregate savings in the economy feeds into
the national supply of capital. Therefore, it can be used to assess the long-term
productive capacity of an economy.

Secondly, consumption behavior provides a good measure of the total national output
in the economy. The total output can be used to understand the reasons for
macroeconomic fluctuations in the business cycle.

The behavior data can be used to measure poverty, understand the retirement rate in
households, and test theories of competition in the economy. Data from households
allows macroeconomists to understand spending behavior, and the figures can be used
to examine relationships between consumption and factors such as unemployment and
education costs.

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 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,
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NATIONAL INCOME

Concept of National Income

National income means the value of goods and services produced by a country
during a financial year. Thus, it is the net result of all economic activities of any
country during a period of one year and is valued in terms of money. National
income is an uncertain term and is often used interchangeably with the national
dividend, national output, and national expenditure. We can understand this
concept by understanding the national income definition

Concept of National Income

The National Income is the total amount of income accruing to a country
from economic activities in a years time. It includes payments made to all
resources either in the form of wages, interest, rent, and profits.

The progress of a country can be determined by the growth of the national

income of the country

National Income Definition

There are two National Income Definition

 Traditional Definition
 Modern Definition

raditional Definition
According to Marshall: “The labor and capital of a country acting on
its natural resources produce annually a certain net aggregate of
commodities, material and immaterial including services of all kinds. This is the
true net annual income or revenue of the country or national dividend.”

The definition as laid down by Marshall is being criticized on the following

grounds.

Due to the varied category of goods and services, a correct estimation is very
difficult.

There is a chance of double counting, hence National Income cannot be

estimated correctly.

For example, a product runs in the supply from the producer to distributor
to wholesaler to retailer and then to the ultimate consumer. If on every
movement commodity is taken into consideration then the value of National
Income increases.

Also, one other reason is that there are products which are produced but not
marketed.

For example, In an agriculture-oriented country like India, there are

commodities which though produced but are kept for self-consumption or
exchanged with other commodities. Thus there can be an underestimation of
National Income.

Read more about Income and Expenditure Method here in detail

Simon Kuznets defines national income as “the net output of commodities and
services flowing during the year from the country’s productive system in the
hands of the ultimate consumers.”

Following are the Modern National Income definition

 GDP
 GNP
Gross Domestic Product

The total value of goods produced and services rendered within a country during
a year is its Gross Domestic Product.

Further, GDP is calculated at market price and is defined as GDP at market

prices. Different constituents of GDP are:

1. Wages and salaries

2. Rent
3. Interest
4. Undistributed profits
5. Mixed-income
6. Direct taxes
7. Dividend
8. Depreciation

Gross National Product

For calculation of GNP, we need to collect and assess the data from all
productive activities, such as agricultural produce, wood, minerals,
commodities, the contributions to production by transport, communications,
insurance companies, professions such (as lawyers, doctors, teachers, etc). at
market prices.

It also includes net income arising in a country from abroad. Four main
constituents of GNP are:

1. Consumer goods and services

2. Gross private domestic income
3. Goods produced or services rendered
4. Income arising from abroad.
GDP and GNP on the basis of Market Price and Factor Cost

a) Market Price

The Actual transacted price including indirect taxes such as GST, Customs duty
etc. Such taxes tend to raise the prices of goods and services in the economy.

b) Factor Cost

It Includes the cost of factors of production e.g. interest on capital, wages to

labor, rent for land profit to the stakeholders. Thus services provided by service
providers and goods sold by the producer is equal to revenue price.

Alternatively,

Revenue Price (or Factor Cost) = Market Price (net of) Net Indirect Taxes

Net Indirect Taxes = Indirect Taxes Net of Subsidies received

Hence,

Factor Cost shall be equal to

(Market Price) LESS (Indirect Taxes ADD Subsidies)

Net Domestic Product

The net output of the country’s economy during a year is its NDP. During the
year a country’s capital assets are subject to wear and tear due to its use or can
become obsolete.

Hence, we deduct a percentage of such investment from the GDP to arrive at

NDP.

So NDP=GDP at factor cost LESS Depreciation.

The Accumulation of all factors of income earned by residents of a country and

includes income earned from the county as well as from abroad.
Thus, National Income at Factor Cost shall be equal to

NNP at Market Price LESS (Indirect Taxes ADD Subsidies)

Question on National Income

Q. Enumerate the various methods of measuring National Income?

Ans. There are various methods for measuring National Income:

1. Gross Domestic Product (GDP)

2. Gross National Product (GNP)
3. Net National Product (NNP)
4. Net Domestic Product (NDP)
5. National Income at Factor Cost (NIFC)
6. Transfer Payments
7. Personal Income
8. Disposable Personal Income