Edexcel A-Level Economics · Revision notes

2.2.2 Consumption (C)

Consumption is spending by households on goods and services, from food and rent to holidays and cars. It is the largest component of aggregate demand in the UK, at around 60% of GDP, so even small changes in household spending have a large effect on the economy. This topic covers what determines it.

Disposable income

The most important influence on consumption is disposable income: the income households have available to spend or save after direct taxes have been deducted and state benefits added.

Disposable income = gross income − direct taxes + state benefits

When disposable income rises, households spend more. When it falls, through job losses, tax rises or wages failing to keep pace with prices, they spend less.

Watch out: What matters is real disposable income, adjusted for inflation: a 3% pay rise when prices rise by 5% leaves households able to buy less.

The marginal propensity to consume (MPC) measures the link between extra income and spending. It is the share of any extra income that is spent:

MPC = change in consumption ÷ change in income

Lower-income households tend to have a higher MPC. They spend most of any extra income because they have more unmet needs. Higher-income households save a larger share of each extra pound.

Savings and consumption

Income that is not spent is saved. Saving and consumption are therefore two sides of the same decision:

Disposable income = consumption + saving

It follows that the marginal propensity to save (MPS) is the share of extra income saved, and in this simple model MPC + MPS = 1.

The household saving ratio measures saving as a percentage of disposable income. When households become more cautious, the saving ratio rises and consumption falls, even if income has not changed. This happened sharply during the 2020 pandemic, when many households could not spend and others saved out of fear for their jobs.

A worked example

A household's disposable income rises from £40,000 to £42,000. Its consumption rises from £36,000 to £37,500.

• MPC = £1,500 ÷ £2,000 = 0.75. Three-quarters of the extra income is spent.
• MPS = 1 − 0.75 = 0.25. A quarter of the extra income is saved.

Other influences on consumer spending

Interest rates

A rise in interest rates tends to reduce consumption:

• Borrowing becomes more expensive, so households buy fewer goods on credit, such as cars and furniture.
• Saving becomes more attractive, because the reward for saving rises.
• Mortgage payments rise for households on variable-rate or expiring fixed-rate mortgages, leaving less income for other spending.

A cut in interest rates has the opposite effects. This is one of the main channels through which the Bank of England influences the economy.

Consumer confidence

When households feel secure about their jobs and future income, they spend more and borrow more freely. When they fear unemployment or falling incomes, they cut back and save more, even before their income actually falls.

Key idea: Confidence can therefore make changes in the economy self-reinforcing: pessimism reduces spending, which reduces output and jobs, which justifies the pessimism.

Wealth effects

Wealth is the stock of assets households own, such as houses, shares and savings. When the value of these assets rises, households feel better off and tend to spend more, even though their income has not changed. Some also borrow against the rising value of their homes.

Rising house prices are the most important wealth effect in the UK, because housing is the largest asset most households own. A fall in house or share prices has the opposite effect.

Key terms

Common mistakes

• Confusing income and wealth. Income is a flow of money over time; wealth is a stock of assets at a point in time.
• Calculating the MPC from total income. The MPC uses the change in consumption divided by the change in income, not the totals.
• Ignoring real income. A rise in money income does not raise spending power if prices rise faster.
• Treating interest rates as working through one channel only. They affect borrowing, saving and mortgage payments.
• Forgetting the confidence effect. Households can cut spending before their income falls.

How this has been examined

In the Edexcel papers indexed on this site, this topic has appeared in seven formats:

• 25-mark "Evaluate" synoptic essay — asked once (2023)
• 8-mark "Examine" data response — asked once (2024)
• 4-mark "Explain" data response — asked once (2022)
• 2-mark calculation — asked twice across 2 series (2019 to 2024)
• 2-mark "Explain" data response — asked twice across 2 series (2017 to 2018)
• 2-mark "Explain" short answer — asked twice across 2 series (2021 to 2024)
• 1-mark multiple choice — asked 4 times across 4 series (2019 to 2024)

It has appeared at every tariff from 1 to 25 marks.

Where this goes next

Consumption is one of the four components set out in 2.2.1 The characteristics of AD, alongside 2.2.3 Investment (I), 2.2.4 Government expenditure (G) and 2.2.5 Net trade (X-M). Saving reappears as a withdrawal in 2.4.2 Injections and withdrawals, and the MPC determines the size of 2.4.4 The multiplier. The Bank of England's use of interest rates to influence spending is covered in 2.6.2 Demand-side policies.