Consumer Demand

Economists have looked at consumer demand both at the macro- or aggregative level and at the level of individual choice (microlevel). At the aggregative level, beginning in the 1930s with the first systems of national accounts, consumption spending, private investment, government outlays, and net exports were dubbed the components of overall demand. Private consumption alone, in recent years, has exceeded two-thirds of all spending in the U.S. economy. John Maynard Keynes, in his book The General Theory of Employment, Interest and Money (1936), explained the depth and persistence of unemployment in the Great Depression as a failure of confidence reflected in too little business investment and private consumer spending. He suggested that consumption depends on current income, and made much of what he called the marginal propensity to consume, or the ratio of consumption to income, which he took to be less than one.

If, through a shock to confidence, a negative change in income occurs, this translates into a negative change in investment or consumption, but that causes a drop in the incomes of those who depend on consumption spending, and so on, through many rounds. The total loss of income here exceeds that of consumption, and both will exceed the initial changes if the marginal propensity to consume is less than one. This is known as the multiplier effect. It works negatively, accentuating downturns, but also positively; and Keynes urged that governments engage in stimulus spending to offset shortfalls in private consumption and investment. Even if this increases the fiscal deficit, the multiplier effect on incomes and thence on tax revenue means that a public stimulus can be self-financing over time.

[Page 257]Argument ensued over the size of the multiplier and as to whether the exogenous income variable should be absolute or relative income. Milton Friedman (A Theory of the Consumption Function, 1957) mounted a more basic challenge, urging that rational economic agents do not respond to current income but spend out of so-called permanent income: the discounted value of expected future income, including years of active earning and years during which savings are drawn. Rational people therefore do not rush to spend a one-time government payment in time of recession. They might spend, but in principle, it will be only that small fraction of a government stimulus that is appropriate after folding the one-time largesse into lifetime income, and bearing in mind that future tax rates may have to be increased to eliminate the government debt issued to cover the one-time outlay. This thinking applies symmetrically to saving, or nonspending, with the implication that such things as the setting up and management of retirement accounts can safely be left to citizens themselves. Almost eighty years of empirical research on these issues has not proved univocal.

Despite the more immediate policy implications coming out of the macroanalysis of consumption, probably more effort in the twentieth century went into the analysis of consumer choice at the microlevel. This was part of bringing consumer choice under the umbrella of rational (that is, utility maximizing) decision making.

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