Marginal propensity to consume (MPC) refers to the proportion of extra income that a person spends instead of saves. The term and its formula are based on observations made by famed British economist John Maynard Keynes in the 1930s during the Great Depression. He noted that individuals have the propensity to consume more when their income increases. MPC is useful because it relates to how a government stimulus might affect the economy.
- Marginal propensity to consume (MPC) measures how much more individuals will spend for every additional dollar of income.
- MPC is calculated as the ratio of marginal consumption to marginal income.
- MPC is related to the so-called Keynesian multiplier, where MPC can help predict the economic growth from a government stimulus.
- The multiplier effect refers to a chain reaction of consumption by various entities brought about by an initial increase in income.
- An MPC of one means a person spent all additional income. An MPC of zero means they spent none of it and, instead, invested it.
Marginal Propensity to Consume
How to Calculate Marginal Propensity to Consume
The formula used to calculate marginal propensity to consume is change in consumption divided by change in income, or, MPC = ∆C/∆Y. To make this calculation, you first must determine the change in income and the resulting change in spending (consumption). If someone's income increases by $5,000 and their spending increases by $4,500, the calculation would be made in this way:
MPC = 4,500/5,000. MPC = .9 or 90%
Origins of Marginal Propensity to Consume
Keynes formally introduced the concept of MPC in his 1936 book, The General Theory of Employment, Interest, and Money. Keynes argued that all new income must either be spent, as with consumption, or invested, as with savings.
Keynes understood that the classical thinking which held that supply would create its own demand did not always work. He noted that the main problem was a lack of aggregate demand. He believed that government spending could add to aggregate demand and that this fiscal stimulus would create a multiplier effect. This effect would result from increases in income and consumer spending that caused a chain reaction of spending by various other beneficiaries of the spending.
Despite the relative simplicity of Keynes' argument about identifying MPC, macroeconomists have not been able to develop a universally accepted method of measuring MPC in the real economy. Much of the problem is that new income is considered to be, both, a cause and an effect on the relationship between consumption, investment, and new economic activity, which generates new income.
Marginal Propensity to Consume Example
Take an employee of ABC Company. They receive a raise in salary. Their spending goes up as a result. What is MPC in this instance? Since the formula for MPC is change in consumption divided by change in income, you must first determine those two changes.
For change in income, the salary rose from $65,000 to $75,000. The change is $10,000 ($75,000 minus $65,000).
For change in consumption, determine levels of spending before and after the salary increase. Before the increase, the employee spent $60,000 of the $65,000 on goods and services. They put the remaining $5,000 into savings. After the salary raise to $75,000, they spent $65,000 on goods and services. The change in consumption is $5,000 ($65,000 minus $60,000).
To calculate marginal propensity to consume, insert those changes into the formula:
MPC = ∆C/∆Y
MPC = 5,000/10,000
MPC = .5 or 50%
This means the individual spent 50% of their added income on goods and services.
An MPC equal to one means that a change in income (∆Y) led to the same proportionate change in consumption (∆C). That is, a person spent 100% of the additional income on goods and services and saved none of it.
An MPC less than one means that a change in income produced a proportionally smaller change in consumption. A person spent less than the added income received.
An MPC equal to zero means that a change of income led to no change in consumption. So, a person spent none of the change in income and, instead, put it into savings.
An MPC that is higher than one means that additional income led to spending that surpassed the amount of additional income.
What Is Marginal Propensity to Consume?
Marginal propensity to consume is a figure that represents the percentage of an increase in income that an individual spends on goods and services.
What Does a High MPC Indicate?
A high MPC indicates that the proportion of increased income spent on goods and services approached the actual amount of that increase. Conversely, a low MPC means an individual spent less of that increase in income and instead, put the money into savings.
What Causes MPC to Increase?
Marginal Propensity to Consume increases when consumption represents more of the amount of the added income rather than less. In other words, a person spends more and saves less. Typically, lower income levels produce a higher MPC than higher income levels.