A Principle of Macroeconomics: Consumption is the Purpose of Production

I have always said that the most important principle of macroeconomics is scarcity. There are not enough resources (land, labor, and capital) to produce enough goods and services (consumer goods and services, capital goods, and government goods and services,) to achieve everyone's goals.

Scarcity is important because it implies that "overproduction" is not a plausible explanation for recession, and that overproduction of some goods should always be understood as implying the under production of other, more valuable goods. While there may be a "general glut" of goods, the problem is some kind of coordination failure rather than too much production of everything. Increasing the productive capacity of the economy--the supplies of resources like land, labor, and capital and the enhancement of resource productivity--is a "good" thing, and the key issue is the allocation of resources to produce the most valuable goods and services.

However, a more fundamental principle of macroeconomics is that the purpose of production is consumption. This principle is worth emphasizing because some criticisms of Keynesian economics by free market economists go too far in dismissing the importance of consumer expenditure for the economy. Production by firms in consumer goods industries is driven by expectations of consumer expenditures in the near future. And the production of many intermediate goods--materials and partially finished goods--while directly driven by expectations of purchases by other firms in the near future, are indirectly driven by expected future consumer expenditures. Since firms will not produce what they do not expect sell, expected consumer expenditures are important in determining both output and employment.

It is not only productive capacity, or "supply" that drives production, employment, and income, it is also expenditure on that productive capacity, or "demand." Both supply and demand are important.

Consider, then, the principle that the purpose of production is consumption. It is not a fact about the world, but rather a judgement about what economic activity should be about. For Robinson Crusoe, alone on this island, the reason he catches fish in the lagoon is to eat the fish. He produces in order to consume. In a social order, including a market order, people produce goods and services for other people to consume, and they consume goods and services that other people produce. If Robinson Crusoe isn't alone, but rather there is a group of people on the desert island, working as a team, it still is clear. They divide up various tasks necessary for survival (produce) in order to obtain the goods and services (food, and shelter) they want (consume.)

However, in a market system, people directly provide resources for sale to others, who use those resources to produce goods and services, in order to sell products to others. They sell these resources and products for money, and then use that money to purchase goods and services. What appears so obvious with Robinson Crusoe alone on his island, or even an isolated team working together, can become muddied in a market economic system. But still, the purpose of production is consumption.

Adam Smith's metaphor of the invisible hand suggests even if the people in a market economic order fail to see that the purpose of their production is consumption, prices should create signals and incentives that coordinate their activities so that their production is directed towards consumption. For example, someone may think that they work to accumulate wealth, but some prices will adjust to a level where their efforts to accumulate wealth become consistent with the purpose of production--the consumption of goods and services.

For the most part, there is no problem at all. People provide resources to others, selling those resources to earn incomes like rents, wages, and interest. Firms use those resources to produce consumer goods and services, capital goods, or government goods and services, to sell them, and receive a revenue that covers their expenses and generates a profit. The profit is income to the owners of the firms, and so the value of the output produced generates a matching income to those providing resources, including the owners of the firms.

For the most part, the reason households want to earn income is consumption, buying consumer goods and services. So while people directly provide resources to firms is to earn income, and the reason firms use the resources to produce goods and services is to pay for the resources and earn profit, people do this mostly to spend the income they earn on consumer goods and services. The provision of resources and the production of goods and services is mostly being directed towards consumption. For the most part, the market economic system creates a flow of employment of resources, production of goods and services, and expenditures on those goods and services consistent with the basic principle that the purpose of production is consumption.

Usually, I think about the economy without government, but explaining how production gets directed towards the provision of government goods and services rather than consumer goods and services is simple. For the most part, governments fund their purchases of resources (like labor) and government goods and services by taxation. Those earning incomes pay taxes to the government. This reduces their disposable income (after tax income) and so their ability to purchase consumer goods and services. The government hires workers and purchases various goods and services. Sadly, this reduces the capacity of the private sector to produce goods and services, which matches the reduction in the ability of households to buy consumer goods and services. (What about budget deficits and budget surpluses? That must wait a bit. )

What about saving? Saving is disposable income less consumption. It is that part of income not paid in taxes or spent on consumer goods and services. If the purpose of production is consumption, does that make saving "bad?"

And what about investment? Firms purchase capital goods--machines buildings and equipment. And, the resources provided by households to firms--the land, labor, and capital--are partly used to produce capital goods. Is the production of capital goods inconsistent with the principle that the purpose of production is consumption? Is investment "bad?"

Saving and investment are consistent with the principle that the purpose of production is consumption to the degree that households save in order to fund future consumption and firms invest in order to produce consumer goods in the future. The key question then, is how (or if) the market process generates prices that create the signals and incentives that cause households to save in order to consume in the future and firms to invest in order to produce consumer goods in the future.

If those prices are not at the right level to provide the correct signals and incentives, it is possible that consumption is too low. If consumption is expected to remain too low in the near future, then the production of consumer goods will likely be too low as well. In that situation, recovery requires expectations of increased consumer expenditure and an increase in the production of consumer goods.

Free market economists who denigrate the need to expand consumption expenditure and insist that somehow, all problems will be solved by an increase in the productive capacity of the economy--greater supplies of land, labor, and capital--are failing to take into account this key principle of macroeconomics--the purpose of production is consumption.