Income Determination – Concept of Consumption and Its Relationship With Savings and Investment

Consumption is the total quantity of goods and services purchased and used by consumers during a specified period of time. Consumption is also described as expenditure on goods and services at a given period of time. It is the expression of total consumer demand. Types of consumption include durable goods, nondurable goods, and services. Durable goods involve consumption expenditure on certain items that are durable in nature, e.g., houses, vehicles, furniture, machines, etc.; non-durable goods involve consumption expenditure on goods that are not durable in nature, e.g., food, clothing, water, etc. Services involve consumption expenditure on general services, e.g., legal fees, medical fees, entertainment fees, educational fees, etc.

Factors that determine the level of Consumption are:

1. Savings: The level of savings influences consumption. High savings influence consumption and tends to reduce the level of consumption.

2. Level of income: The higher the income, the higher the level of consumption.

3. Availability of credit facilities: Availability of credit facilities either to individuals or firms tends to increase consumption level.

4. Income distribution; Equitable distribution of national income will increase individuals’ disposable income, thereby increasing the level of consumption.

5. Possession of assets: Revenue generated by assets increases their owners’ income, which tends to raise the level of consumption.

6. Rate of taxation: High taxation reduces people’s income, which reduces the level of consumption.

7. an Interest rate; If the interest rate received is high, it will generally increase the income, leading to a rise in consumption level.

8. Profit earned: High profits earned either by individuals or firms increase income, thereby resulting in a rise in consumption level.

9. Future expectation: the expectation of rising in the prices of goods and services will lead to a rise in consumption expenditure and vice versa.

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Relationship between savings, Investment, and Consumption

Savings, investment, and consumption are closely related. We save to accumulate capital for investment and many other personal reasons. There will be no investment without savings. Investment, in turn, creates employment and income for people. Without it and, therefore, without income, we shall have nothing to save and nothing to spend on consumer goods and services.

What we do not spend is what is saved. Consumption, therefore, is affected by decisions to spend. If we spend all our income, there will be no capital accumulation for investment. Therefore, the community’s income is made up of savings, investment, and consumption. Savings, investment, and consumption are related to income with the use of the following formula:
Y= C + S
Y= C + I
S= I, where Y is income, C is consumption expenditure, and I is investment expenditure.

Propensities to Consume

Propensities to consume can be in two groupings:

I. Average propensity to consume (APC): The APC is defined as the proportion of the national income consumed. To calculate APC, the total national consumption is divided by the total national income. The formula is:
APC= Total National Consumption/Total National income = C/Y.

For example, Belarus’s total national income is $20 million, and the total national consumption is $5 million. To find the APC, it will be $5m/$20m = 0.4

II. Marginal propensity to consume (MPC)
The MPC is defined as the relationship between changes in income and changes in consumption. It shows the extent to which the level of consumption changes due to a change in income. It, therefore, shows the proportion of any addition to income, which is used for consumption.
MPC = changes in consumption/Changes in income = dC/dY

For example, if the monthly income of an individual increase from $10,000 to $15,000 and increases his level of consumption from $4,000 to $6,000, his marginal propensity to consume can be calculated as follows:
initial income per month= $10,000
New income per month= $15,000
Changes in income (dY) = $15,000-$10,000= $5,000
Initial consumption per month= $4,000
New consumption per month= $6,000
Changes in consumption (dC)= $6,000-$4,000= $2,000.
MPC= dC/dY= $2,000/$5,000= 0.4 This is low and hence good for his savings and financial growth.

Propensity to save
This is also in two groupings

The average propensity to save: The average propensity to save is defined as a measure of the proportion of saved income (not spent on consumption). It shows the expected amount of savings at different levels of income.

APS= Total National Savings/Total National Income = S/Y
The APS increases with increasing income. As the level of income increases, one can save more money.
Note that APC + APS = 1.

For example, if Makama Incorporation firm earns $80 billion and spent $50 billion on procurement of working materials, the APS of the firm would be;
Total income= $80 billion
Total expenditure= $50 billion
Total savings = Total income – Total expenditure = $80 billion – $50 billion = $30 billion
Therefore, APS = Total savings/total income = $30 billion/$80 billion = 0.38