What is the 'Average Propensity To Consume'
The average propensity to consume refers to the percentage of income spent on goods and services rather than on savings. A person can determine the percentage of income spent by dividing the average household consumption, or what is spent, by the average household income, or what is earned. The inverse of the average propensity to consume is the average propensity to save (APS).
BREAKING DOWN 'Average Propensity To Consume'Economic periods where consumers are spending can boost the economy. More goods are purchased; there is a high demand for goods and services, keeping more people employed and more businesses open. Periods when the tendency to save is increased can have a negative effect on the economy as people purchase fewer goods and services; there is a low demand for goods and services, resulting in fewer jobs and increased business closures.
Low-income households are thought to have a higher average propensity to consume than high-income households. Low-income households tend to spend more of their disposable income on basic necessities than high-income households, which causes the higher percentage of income spent on goods and services.
Difference Between Average Propensity to Consume and Average Propensity to Save
The sum of the average propensity to consume and the average propensity to save is equivalent to 1 because households use income for saving and consumption. Contrary to the average propensity to consume, the APS is calculated as the percentage of total income used for saving rather than spending on goods and services. The average propensity to consume could also be calculated by subtracting the APS from 1.
For example, assume an economy has a gross domestic product (GDP) equivalent to its disposable income of $500 billion for the previous year. The total savings of the economy was $300 billion, and the rest was spent on goods and services. Consequently, the APS is calculated to be 0.60, or $300 million/$500 million. This indicates the economy spent 60% of its disposable income on savings. Conversely, the average propensity to consume is calculated to be 0.40, or (1 - 0.60). Therefore, the economy spent 40% of its GDP on goods and services.
Marginal Propensity to Consume
The marginal propensity to consume is a key concept and measures the change in the average propensity to consume. Assume in the previous example, the economy increased its GDP to $700 billion and its consumption of goods and services increased to $375 billion. The economy's average propensity to consume increased to 53.57%, and its marginal propensity to consume was 87.50%; therefore, 87.50% of its additional GDP, or disposable income, was spent on goods and services.