What Is Marginal Propensity to Consume (MPC)?
In economics, the marginal propensity to consume (MPC) is defined as the proportion of an aggregate raise in pay that a consumer spends on the consumption of goods and services, as opposed to saving it. Marginal propensity to consume is a component of Keynesian macroeconomic theory and is calculated as the change in consumption divided by the change in income.
MPC is depicted by a consumption line, which is a sloped line created by plotting the change in consumption on the vertical “y” axis and the change in income on the horizontal “x” axis.
- Marginal Propensity to Consume is the proportion of an increase in income that gets spent on consumption.
- MPC varies by income level. MPC is typically lower at higher incomes.
- MPC is the key determinant of the Keynesian multiplier, which describes the effect of increased investment or government spending as an economic stimulus.
Understanding Marginal Propensity to Consume (MPC)
The marginal propensity to consume is equal to ΔC / ΔY, where ΔC is the change in consumption, and ΔY is the change in income. If consumption increases by 80 cents for each additional dollar of income, then MPC is equal to 0.8 / 1 = 0.8.
Suppose you receive a $500 bonus on top of your normal annual earnings. You suddenly have $500 more in income than you did before. If you decide to spend $400 of this marginal increase in income on a new suit and save the remaining $100, your marginal propensity to consume will be 0.8 ($400 divided by $500).
The other side of the marginal propensity to consume is the marginal propensity to save, which shows how much a change in income affects levels of saving. Marginal propensity to consume + marginal propensity to save = 1. In the suit example, your marginal propensity to save will be 0.2 ($100 divided by $500).
If you decide to save the entire $500, your marginal propensity to consume will be 0 ($0 divided by 500), and your marginal propensity to save will be 1 ($500 divided by 500).
MPC and Economic Policy
Given data on household income and household spending, economists can calculate households’ MPC by income level. This calculation is important because MPC is not constant; it varies by income level. Typically, the higher the income, the lower the MPC because as income increases more of a person’s wants and needs become satisfied; as a result, they save more instead. At low-income levels, MPC tends to be much higher as most or all of the person’s income must be devoted to subsistence consumption.
According to Keynesian theory, an increase in investment or government spending increases consumers’ income, and they will then spend more. If we know what their marginal propensity to consume is, then we can calculate how much an increase in production will affect spending. This additional spending will generate additional production, creating a continuous cycle via a process known as the Keynesian multiplier. The larger the proportion of the additional income that gets devoted to spending rather than saving, the greater the effect. The higher the MPC, the higher the multiplier—the more the increase in consumption from the increase in investment; so, if economists can estimate the MPC, then they can use it to estimate the total impact of a prospective increase in incomes.
What Is Marginal Propensity to Consume in Simple Terms?
The marginal propensity to consume measures the degree to which a consumer will spend or save in relation to an aggregate raise in pay. Or, to put it another way, if a person gets a boost in income, what percentage of this new income will they spend? Often, higher incomes express lower levels of marginal propensity to consume because consumption needs are satisfied, which allows for higher savings. By contrast, lower-income levels experience a higher marginal propensity to consume since a higher percentage of income may be directed to daily living expenses.
How Do You Calculate Marginal Propensity to Consume?
To calculate the marginal propensity to consume, the change in consumption is divided by the change in income. For instance, if a person’s spending increases 90% more for each new dollar of earnings, it would be expressed as 0.9/1 = 0.9. On the other hand, consider a person receives a bonus of $1,000 and spends $100 of this while saving $900. The marginal propensity to consume would equal $100/$1,000 or 0.1.
What Role Does the Marginal Propensity to Consume Have in Economics?
In Keynesian macroeconomic theory, the marginal propensity to consume is a key variable in showing the multiplier effect of economic stimulus spending. Specifically, it suggests that a boost in government spending will increase consumer income, and in turn, consumer spending will rise. On a macro level, this increase in investment will lead to a higher aggregate level of demand.