2.2.2 - Consumption (C)

Disposable Income and Spending Power

The main immediate influence on consumption is disposable income. Households can only keep spending if they have money left after direct taxes have been paid and any benefits have been received.

The relationship can be shown as:

If wages rise, or if the government cuts income tax or increases benefits, disposable income usually rises and consumption tends to increase. If taxes rise or benefits are cut, the opposite is likely. For example, if a UK household receives more Universal Credit or faces a smaller income tax bill, it has more money available for day-to-day spending.

Propensities to Consume

An increase in income does not all have to be spent. Economists therefore look at how much of extra income is consumed and how much is saved.

If income rises by GBP100 and a household spends GBP80 of it, its marginal propensity to consume is 0.8. MPC is usually positive but less than 1 because at least some extra income is often saved.

Poorer households usually have a higher MPC than richer households. More basic needs are still unmet, so extra income is likely to be spent quickly on essentials. Richer households are more likely to save part of any extra income because their immediate needs are already covered.

This is why the distribution of income matters. If income becomes more equal, for example through progressive taxation or higher benefits for lower-income households, total consumption tends to rise because income is shifted towards people with a higher MPC. If income becomes more concentrated among higher earners, overall consumption may grow more slowly because a larger share of income is saved.

Average propensity to consume, or APC, measures the proportion of total income spent on consumption:

In most industrialised economies APC is below 1 because some income is saved, and APC often falls as income rises because wealthier households usually save a larger fraction of their income. APC can be above 1 for a household that spends more than its income by borrowing or by running down past savings (dissaving).

Worked example: if a household has total income of GBP2,000 and spends GBP1,800, its APC is 0.9. If its income then rises by GBP100 and spending rises by GBP70, its MPC is 0.7. APC looks at total income; MPC looks only at the change in income. After the rise, its APC is GBP1,870 / GBP2,100, about 0.89: the extra income is spent at a lower rate (0.7) than the old average (0.9), so APC falls slightly as income rises.

Saving and Key Relationships

Saving is the part of disposable income that is not spent on consumption. That means disposable income (Y in the formulas below) is always divided between consumption and saving.

If a household spends more out of an extra pound, it must be saving less of that pound. If households become worried about recession or unemployment, they may increase precautionary saving and reduce consumption even when current income has not yet changed. For example, the UK household saving ratio (the share of household disposable income that is saved) rose to a record high in 2020 during the COVID-19 lockdowns, partly because many shops and restaurants were closed and partly because of precautionary saving, while consumption fell sharply.