Where did all that Money Go? Understanding how Consumers Allocate their Consumption Budget

Abstract

All types of consumer expenditures ultimately vie for the same pool of limited resources—the consumer's discretionary income. Consequently, consumers’ spending in a particular industry can be better understood in relation to their expenditures in others. Although marketers may believe that they are operating in distinct and unrelated industries, it is important to understand how consumers, with a given budget, make trade-offs between meeting different consumption needs. For example, how much would escalating gas prices affect consumer spending on food and apparel? Which industries would gain most in terms of extra consumer spending as a result of a tax rebate? Answers to these questions are also important from a public policy standpoint because they provide insights into how consumer welfare would be affected as consumers reallocate their consumption budget in response to environmental changes. This study proposes a structural demand model to approximate the household budget allocation decision, in which consumers are assumed to allocate a given budget across a full spectrum of consumption categories to maximize an underlying utility function. The authors illustrate the model using Consumer Expenditure Survey data from the United States, covering 31 consumption categories over 22 years. The calibrated model makes it possible to draw direct inferences about the trade-offs individual households make when they face budget constraints and how their relative preferences for different consumption categories vary across life stages and income levels. The study also demonstrates how the proposed model can be used in policy simulations to quantify the potential impacts on consumption patterns due to shifts in prices or discretionary income.