Understanding Consumer Behavior

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Consumption is the sole end and purpose of all production.

—Adam Smith

How do households decide how much of their income to consume today and how much to save for the future? This is a microeconomic question because it addresses the behavior of individual decisionmakers. Yet its answer has important macroeconomic consequences. As we have seen in previous chapters, households’ consumption decisions affect the way the economy as a whole behaves both in the long run and in the short run.

The consumption decision is crucial for long-run analysis because of its role in economic growth. The Solow growth model of Chapter 8 and Chapter 9 shows that the saving rate is a key determinant of the steady-state capital stock and thus of the level of economic well-being. The saving rate measures how much of its income the present generation is not consuming but is instead putting aside for its own future and for future generations.

The consumption decision is crucial for short-run analysis because of its role in determining aggregate demand. Consumption is two-thirds of GDP, so fluctuations in consumption are a key element of booms and recessions. The IS–LM model of Chapter 11 and Chapter 12 shows that changes in consumers’ spending plans can be a source of shocks to the economy and that the marginal propensity to consume is a determinant of the fiscal-policy multipliers.

In previous chapters we explained consumption with a function that relates consumption to disposable income: C = C(Y − T). This approximation allowed us to develop simple models for long-run and short-run analysis, but it is too simple to provide a complete explanation of consumer behavior. In this chapter we examine the consumption function in greater detail and develop a more thorough explanation of what determines aggregate consumption.

Since macroeconomics began as a field of study, many economists have written about the theory of consumer behavior and suggested alternative ways of interpreting the data on consumption and income. This chapter presents the views of six prominent economists to show the diverse approaches to explaining consumption.

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