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Economic Activity (Y ) = C + I + G + (X − M)

When classifying the purchases and expenditure that occur in an economy (as C, I or G, X or M ), economists classify them according to their purpose or function. A pair of shoes bought by a consumer for the purpose of wearing them would be part of consumption expenditure (C). The same pair of shoes in the manufacturer’s factory before being distributed for sale is a component of investment – inventory investment (I ). If the pair of shoes were bought by the government for a member of the army the expenditure would be part of G – government expenditure. Shoes produced abroad and imported appear under imports while if the shoes are produced for an external market they appear as exports. To ensure that output is not counted twice, imported shoes would not also be included in consumption or government expenditure.

Each component of economic activity can be studied separately and in this chapter we deal with consumption, the most substantial component. Table 3.1 shows the percentage share of consumption expenditures out of the value of total economic activity for a number of economies.

Table 3.1 illustrates the sizeable share of consumption in economic activity for those countries considered. Almost 70% of the income in the USA was spent on consumption goods and the value of US consumption is estimated at 20% of world output. It is important for economists to understand what impacts on this component of economic activity.

T A B L E 3 . 1 C O N S U M P T I O N S H A R E ( % ) O F E C O N O M I C A C T I V I T Y , 2 0 0 0

	USA	UK	France	Ireland	Germany	Japan
Consumption Share	68	75	66	60	69	62
Source: Excerpted from the Penn World Table 6.1 (Heston et al., 2002).

3.2.1CONSUMPTION GOODS

Consumers derive benefit, satisfaction or utility from the goods they consume. Consumption goods are made up of three broad categories of goods that consumers demand – durable and non-durable goods, and services.

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If consumer confidence is low or declining, it indicates that consumers consider economic activity to be slowing down or that the economy is in a recession so they prefer to put off durable purchases because they expect the economy to improve in the future. An economy is in recession if economic activity declines for a substantial period. Recessions are characterized by periods when consumers buy fewer goods and services than previously and when many people who are willing and able to work lose their jobs as demand for their output declines. A recession that lasts for a long period is called a depression – as in the Great Depression that followed the Wall Street Crash of 1929.

T H E G R E A T D E P R E S S I O N

Economically speaking, the roaring twenties were a good time in the USA for business growth, jobs, share prices and profits. Stock market speculation, riotous spending and real estate booms sent prices skyrocketing. On 24 October 1929, many shareholders began to lose confidence and, believing that the prices of the shares they owned could not rise forever, decided to sell.

Within the first few hours of the stock market opening that day, prices fell so much that all the gains that had been made in the previous year were wiped out. Public confidence was shattered because the stock market had been viewed as a chief indicator of the state of the American economy.

The cause of the crash has been much debated. Some blame an interest rate increase a couple of months before, others the fact that na¨ıve investors had bought stock with credit which was too freely available, believing that stock prices only moved in an upward direction. Some observers believed that stock market prices in the first six months of 1929 were overpriced, but not all agreed. The most likely scenario is that a combination of factors united together to bring about such dramatic outcomes.

Clearly, no one knew what the outcome of the crash would be. Given the economic uncertainty, many firms cut back their plans to purchase producer durables, until a clearer picture emerged. But this caused a further decrease in the demand for producer durables, and led to a fall in production. As production fell, firms needed fewer workers. Unemployed consumers and those who feared they might soon be out of work cut back on their consumer durable purchases. Therefore, firms producing consumer durables faced falling demand as well.

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The vicious circle continued as America sank steadily into the worst depression in its history. Millions of people lost every cent they owned. Half of all US banks failed, factories shut down, shops closed and almost every business seemed paralysed. By the end of 1930 more than 6 million Americans were out of work; by 1931 that had doubled to 12 million. Between 1929 and 1939 real output fell by 30% and living standards in 1939 were lower than in 1929. Over 5000 banks failed and over 32 000 businesses went bankrupt. The slide into the Depression, with increasing unemployment, falling production, and falling prices, continued until the effort for World War Two started.

The USA was far from the only country affected by the Depression. Unemployment rates of over 30% in Germany into the 1930s provided an environment for the policies of the National Socialist German Workers Party, and the career of its leader Adolf Hitler, to flourish with the devastating consequences that ensued internationally.

Non-durable goods include food, clothes, petrol, drugs, and top-up cards for mobile phones and these are usually consumed in less than one year. Services include things like telephone calls, health services (a visit to the doctor, or an operation), or a trip to the cinema.

Services are non-material or intangible items of consumption that are consumed as they are created.

In proportionate terms, consumption spending in developed economies is made up of mostly services (60% plus of total consumption spending), with non-durable goods of approximately 30% and the remainder made up by durable goods. Services are the least volatile component of consumption tending not to vary too much over time, with non-durables next and durable goods the most volatile of the three.

3 . 3 C O N S U M E R S A T I S F A C T I O N – U T I L I T Y

Using the concept of utility, it is possible to consider consumer behaviour and how it underlies demand. Utility increases with the consumption of goods up to a point. For example, the utility or satisfaction from consuming a fifth chocolate bar in a day will surely not be as great as that derived from the first, and this is

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T A B L E 3 . 2 T O T A L A N D

M A R G I N A L U T I L I T Y : C O N S U M I N G

C H O C O L A T E B A R S

Number of bars	Total utility	Marginal utility
(Q)	(TU)	( TU/Q)
0	0	–
1	33	33
2	53	20
3	65	12
4	71	6
5	71	0
6	65	−5

the same for the majority of goods. Table 3.2 shows the total utility and marginal utility from consuming chocolate bars for one consumer who was asked to try to quantify and rank the satisfaction they derive from consuming chocolate bars over one day.

Total utility (TU ) is the total benefit perceived by the consumer from consumption of a good/service.

Marginal utility is the change in total utility for each additional good/service consumed. It is estimated as TU /Q .

Considering the total utility column in Table 3.2, we see that the satisfaction derived from consuming four bars is 71 and has risen with each bar consumed. Above four bars, the consumer’s utility rises no more and with six bars, total utility actually declines because the consumer has chocolate overload!

Looking at the marginal utility column in Table 3.2, we consider the additional benefit derived from each extra bar consumed. This shows a decline from 33 units of satisfaction from the first bar, to 20 units from the second and so on. By the time the consumer consumes the fifth bar, they derive no additional satisfaction as their appetite for chocolate has been adequately satisfied.