Consumption is one of the components of a country’s gross domestic product. It can be defined as the spending on goods and services made by households. Consumption includes only the expenses for final use, not with the intention of generate another product.

Household or private consumption is mainly determined by disposable income (Y_D), which is the money they have earned from wages and other retributions from the firms’ use of factors of production, after government intervention (subtracting taxes from unemployment benefits and other transfers). At the same time, the disposable income is influenced by the marginal propensity to consume (c₁) of households, which is between 0 and 1. However, there is a minimum level of consumption (c₀), also called autonomous consumption, which households make, independently of their disposable income. Therefore, we have:

C = c₀ + c₁ Y_D

Looking at this formula, we can see that households’ consumption may be higher than their disposable income. For example, when the disposable income is zero, the consumption is equal to c₀, a figure different from zero. This is possible because households can borrow money or reduce their savings. Savings are the part of the disposable income that households do not spend, the money they keep, for example, in a bank account. Past savings may allow households to consume during a period more than their disposable income.

This function was first introduced by John Maynard Keynes in his “The General Theory of Employment, Interest and Money”, 1936. Thanks to his work, he is considered as the father of macroeconomics.

Gross domestic product (GDP) is the market value of all final goods and services produced within an economy in a given period of time. This means that we take into account the market value of products of a given country, including nationals and foreigners working in that country. This is the main difference with the gross national product, which considers goods produced only by nationals of a country, without considering their residence.

Note that GDP is calculated over a given period of time, which makes it easy to compare it with other periods or the GDP of other countries. It has also two important implications: goods resold are not considered in the GDP; and goods finalised but not sold are considered as inventory.

We can estimate it using one of three methods. The income approach considers all wages, interests paid, rent and other sources of income to estimate GDP. The production approach estimates gross value and then subtracts intermediate consumption, considered as goods and services used in the making of final goods and services. Finally, there is the expenditure approach, which looks at the demand side.

The expenditure approach considers total expenditure, considering everyone in the economy, such as households, firms and government. GDP (also denoted as Y, production) can be disaggregated into four big components that classify the nature of the expenditure. These components are consumption (C), investment (I), government spending (G) and net exports (NX). With all these variables we can define the following identity:

Y = C + I + G + NX

Any amount of money spent in an economy can be classify into one of the four components of the identity, taking into account the nature of the product, the buyer and the purpose of the spending.

The evolution during the years of a country’s GDP shows the performance of its economy. When GDP is bigger year after year, we can consider it as a sign of a growing economy.  Inflation must be considered when analysing gross domestic product, in order to differentiate nominal and real GDP. Nominal GDP considers only current prices, while real GDP is calculated using prices of a base year, in order of eliminate the effects of inflation

Additionally, if we look at the GDP per capita, dividing the GDP between that country’s total population, we can compare the living standards among countries. However, this measures does not completely represent the welfare of a country’s population, since other things must be taken into consideration.

The circular-flow diagram (or circular-flow model) is a graphical representation of the flows of goods and money between two distinct parts of the economy:

-market for goods and services, where households purchase goods and services from firms in exchange for money;

-market for factors of production (such as labour or capital), where firms purchase factors of production from households in exchange for money.

The market for goods and services is the place where households spend their money buying goods and services produced by firms. In other words, is the place where firms sell the goods and services they have produced, receiving a revenue paid by households.

This market represents the place where money and goods are exchanged. In this case, the flow of money (green arrow in the diagram below) goes from households to firms, in exchange for finished products, which flow from firms to households (red arrow).

The market for factors of production is the place where households offer their labour, capital and other factors such as land, receiving an income for their use. Firms use these factors in their production.

In this case, money flows from firms to households (green arrow in the diagram below) in the form of wages in exchange for labour, interests for capital and rent for the use of land. Factors of production flow form households (red arrow) to firms, so they can produce more goods and services. 

When we combine both diagrams, we get the circular-flow diagram, as shown below. The exchanges made in the economy imply a redistribution of rent according to the diagram, and the creation of value makes the economy grow.

It’s worth mentioning that, as usually, diagrams do not shown how the economy actually works. There are a few things that are not showed in this diagram that must be taken into account to really understand how the economy of a country works. For instance, take government intervention. Things such as government spending (in the form of unemployment benefits, for example) or government income (taxes) are not shown in the diagram.

However, this diagram introduces a clear view of how the economy works. The way of measuring all these flows of money is the gross domestic product (GDP). It can be estimated using one of three methods: looking at total expenditure, at total income or using the production approach.

Macroeconomics is the study of the economy as a whole, by means of aggregate variables, this is, the part of economic theory that studies the behaviour of economic agents in large aggregates of demand and supply, monetary aggregates, gross domestic product, etc. Macroeconomics therefore relate to the concepts of the national economy that are measured through national accounting, input-output models, etc. During the 30s, J.M. Keynes, promoted the study of this matters with his concepts of aggregate demand, full employment and so on.

In contrast to microeconomics, macroeconomics seeks the “large picture”, showing the operations of the economy as a whole, rather than its internal diversity. In fact, it regards the economy as producing a single and unique good. Its purpose is to obtain the least complex vision of the economy’s functioning, but in such a way that it also, allows the analysis of the level of economic activity.

We can use Engel’s Law to show the close relations between micro and macro concepts and how one can have profound implications in the other. Ernst Engel analysed Belgian working class families’ consumption patterns and related their levels of income with their expenditure on food and other goods. He discovered that the higher the income of the family, the lower the share of food in comparison to other expenses. This analysis would become the central statement of his law. As Engel already realized, this had huge consequences in the economic development. Agriculture production, which relies heavily on food consumption, as this is its main product, will see a decline regarding its share of the aggregate total production, as the share for food decreases in aggregate terms as the economy grows. From this concept, we can extract that growth of all sectors at the same rate is impossible, and we also find the close relation between micro and macro concepts.

There are a many topics covered in the field of macroeconomics:  aggregate demand and supply, business cycles, unemployment, government role, inflation, etc.

The Little criterion was developed by Ian M.D. Little in his paper “A Critique of Welfare Economics”, 1949, and it constitutes a further step for compensation principle theory. Little criticises the separation between efficiency and distribution and he demands as in Scitovsky’s criterion, for the Kaldor’s and Hicks’ criteria to hold. Furthermore, this criterion also requires that the income distribution is not worsened by the change of states.

This criterion however, brings some limitations, as a result of its implicit value judgement. The criterion will be met, if by a change of states the positively affected individual (winner) is poorer than the negatively affected individual (loser). As an example, let’s analyse the following graph, where we consider the utility of two individuals (A on the x-axis and B on the y-axis), which we will compare using the utility possibility frontier of two different moments.

Kaldor’s criterion is met when going from X to Y, Y to X or Y to Z, but not when going from Z to Y. However, Hicks’ criterion is only met when going from Y to Z. Therefore, when comparing state Y to Z, winners can compensate the loss of the losers, but losers cannot compensate the other part in order to avoid the change. This is the only case in our example where the Scitovsky criterion is met, making Z preferred to Y. However, Little’s criterion is only met if individual B is poorer than individual A.

Kelvin Lancaster and Richard G. Lipsey, in their article “The General Theory of Second Best”, 1956, following an earlier work by James E. Meade, treated the problem of what to do when certain optimality conditions (which must be considered in order to arrive at a Paretian optimum solution in a general equilibrium system) cannot be satisfied. The main idea in this article is that, when a constraint prevents the fulfilment of one of these conditions, the other conditions are in general no longer desirable. The optimum situation in this case can be attained only by neglecting the other conditions. Indeed, this new optimum is called “second best” because a Paretian optimum cannot be attained.

This can be easily understood using the diagram depicted in the article. We start by considering a typical optimization problem, with a given production possibility frontier (PPF) considered as a boundary condition, indifference curves (green curves, in this case representing a welfare function, ω) and the optimum where the PPF is tangent to ω (point P). Since this points lies on the transformation line and an indifference curve, it defines the production and consumption optima.

When we draw a new constraint condition (red curve), it can be easily seen that point P is no longer attainable. Q could be a second best solution, since it lies both on PPF and NewCC. However, as the authors point out, the second best point would be R, inside the transformation line. This is so because an improvement on welfare can be attained by moving to point R, since it lies on a further indifference curve (ω’’), and therefore means higher welfare.

The segment MN is technically more efficient than R, but since the points on this segment cannot be attained, R is the second best solution.

The Samuelson criterion, sometimes referred to as the Samuelson condition, was raised by the economist Paul A. Samuelson in his paper “Evaluation of Real National Income”, 1950, and belongs to the theory of welfare economics and used as a condition for the efficient provision of public goods. This critique provides a way to avoid intransitivity problems: state X will be preferred to Y if the alternative of X, X’, is preferred to the alternative of Y, Y’.

This criterion however, brings some limitations, since it is very similar to Pareto optimality. Samuelson explains that previous compensation criteria, such as Kaldor’s, Hicks’ or Little’s, hold just because they consider partial redistribution.