Marginal Propensity to Consume

The percentage of additional income spent is known as marginal propensity to consume.

Author: Kevin Henderson
Kevin Henderson
Kevin Henderson
Private Equity | Corporate Finance

Kevin is currently the Head of Execution and a Vice President at Ion Pacific, a merchant bank and asset manager based Hong Kong that invests in the technology sector globally. Prior to joining Ion Pacific, Kevin was a Vice President at Accordion Partners, a consulting firm that works with management teams at portfolio companies of leading private equity firms.

Previously, he was an Associate in the Power, Energy, and Infrastructure Investment Banking group at Lazard in New York where he completed numerous M&A transactions and advised corporate clients on a range of financial and strategic issues. Kevin began his career in corporate finance roles at Enbridge Inc. in Canada. During his time at Enbridge Kevin worked across the finance function gaining experience in treasury, corporate planning, and investor relations.

Kevin holds an MBA from Harvard Business School, a Bachelor of Commerce Degree from Queen's University and is a CFA Charterholder.

Reviewed By: Josh Pupkin
Josh Pupkin
Josh Pupkin
Private Equity | Investment Banking

Josh has extensive experience private equity, business development, and investment banking. Josh started his career working as an investment banking analyst for Barclays before transitioning to a private equity role Neuberger Berman. Currently, Josh is an Associate in the Strategic Finance Group of Accordion Partners, a management consulting firm which advises on, executes, and implements value creation initiatives and 100 day plans for Private Equity-backed companies and their financial sponsors.

Josh graduated Magna Cum Laude from the University of Maryland, College Park with a Bachelor of Science in Finance and is currently an MBA candidate at Duke University Fuqua School of Business with a concentration in Corporate Strategy.

Last Updated:November 28, 2023

What Is Marginal Propensity to Consume (MPC)?

The percentage of additional income spent is referred to as marginal propensity to consume (MPC). To put it another way, if a person has $1, how much would they spend and consume?

The activity or likelihood of spending is referred to as 'propensity,' which refers to a person's desire or tendency to do something. 

As a result, when we talk about the marginal propensity to consume, we're talking about a person's predisposition to consume additional income and the percentage they'd spend.

The marginal propensity to consume, which refers to the percentage of income spent, is generally between 0 and 1. Of course, the consumer can spend none or all of it, but it usually falls somewhere in the middle.

The marginal propensity to save, on the other hand, is the percentage of additional income that the recipient holds rather than spends. The marginal tendency to consume and save when added together equals 1.

The marginal propensity to consume plus the marginal propensity to save is equal to one.

Key Takeaways

  • The marginal propensity to consume measures how much a consumer will spend or save in response to a wage increase. To put it another way, what percentage of a person's new income will they pay if they earn a raise?
  • Higher incomes frequently show decreased MPC because consumption demands are met, allowing for more savings. 
  • Lower-income people, on the other hand, have a higher MPC since a more significant portion of their income may be spent on daily living expenditures.
  • The MPC is calculated by dividing the change in consumption by the change in income. 
  • MPC + MPS is always equal to 1.
  • The marginal willingness to consume is an essential variable in demonstrating the multiplier effect of economic stimulus spending in Keynesian macroeconomic theory. 
  • It indicates that increasing government expenditure will raise consumer income, leading to increased consumer spending. This rise in investment will result in a higher aggregate level of demand on a macro level.

Marginal Propensity to Consume Formula

Its formula is given by the change in consumption divided by the change in income:

MPC = Change in Consumption / Change in Income

If a consumer's income rises by $1 and he spends $0.60, the formula is 0.6/ 1, which equals 0.6.

If you received a $2000 bonus this year, you would have $2000 more than you had last year - a $2000 increase in your income. Let's say you spent $1000 of your newfound wealth. 

It reflects a $1000 increase in consumer spending. As a result, the formula divides the new expense ($1000) by the new income ($2000), resulting in 1000/2000 = 0.5.

As a result, we're left with a marginal inclination to save. Money is conserved if it is not spent on the economy. It is calculated with the following formula:

MPS = Change in Savings / Change in Income

The marginal propensity to save in this situation is equal to the change in consumer savings ($1000) divided by the change in income ($2000), or 1000/2000 = 0.5.

Types of MPC

The three types are as follows:

  • MPC equal to 1: When the MPC is equal to 1, it shows that the entire additional income has been consumed. For example: If Jake earns a bonus of $200 and spends the whole amount, then MPC=1.
  • MPC equal to 0: When MPC is equal to 0, it shows that the entire additional income has been saved. For example: If Jake earns a bonus of $200 and puts the whole amount in the bank account, then MPC=0 or MPS=1.
  • MPC between 0 and 1: In general, MPC is always between 0 and 1 since households save a proportion of their additional income.

Can marginal propensity to consume be greater than one?

It's plausible that consumers have a higher MPC than 1. If their income rises by $10, they may boost their spending by $11 in certain situations; they fund this extra spending by borrowing.

People need to retain particular spending patterns. Therefore a $10 decrease in income is unlikely to result in a reduction in expenditure (known as autonomous consumption).

What is Autonomous Consumption?

It is the degree of consumption that is unaffected by one's income. The reasoning is that even if you have no income, you must acquire enough food to eat by borrowing or depleting your savings.

Consumption impacted by income levels is known as induced consumption.

Autonomous consumption is crucial in the Keynesian model of aggregate expenditure.

Even if a person does not have money, they require necessities such as food, shelter, utilities, and medical care. These expenses, regardless of personal income, cannot be avoided, and as a result, they are considered autonomous or independent.

Autonomous consumption contrasts with discretionary consumption, which refers to non-essential products and services that are desirable if a consumer's available income allows them to purchase them.

If a consumer's income were to deplete for an extended period, they would have to either dive into savings or take on more debt to cover necessary needs.

The quantity of autonomous spending can fluctuate when circumstances limit or destroy sources of income or when available savings and financing options are limited. Downsizing a home, changing one's eating habits, and limiting the use of certain utilities are all examples.

Government expenditure can have a substantial impact on the economy's autonomous spending. For example, when governments raise funding for programs like Social Security to run smoothly, the individual's financial burden is decreased. 

They are government-mandated expenditures, often known as autonomous expenditures.

On the other hand, the government may engage in discretionary spending, such as education programs and free public transportation. In most cases, a well-functioning social welfare system leads to an increase in household savings.

MPC And the Economy

Economists can compute households' MPC by income level using household income and consumption data. This computation is critical because MPC is not constant and varies according to income level. 

The lower the MPC, the higher the income, since when a person's income rises, more of their desires and needs are met; as a result, they save more. 

Because most or all of a person's income must be allocated to subsistence consumption, MPC is significantly higher at low-income levels.

According to Keynesian theory, a surge in government spending or investment raises consumer income, causing them to spend more. So, if we know their marginal propensity to consume, we can calculate how much an increase in production will affect spending.

This new spending will generate additional production through a mechanism known as the Keynesian multiplier, establishing a continuous cycle. The greater the effect, the greater the share of the excess money spent rather than saved. 

An initial injection into a circular flow of money can cause a multiplying effect known as the multiplier effect. In other words, government investment of $20 million can result in a $40 million economic boom. 

This is because the initial investment changes hands multiple times, increasing demand for more and more products and causing a domino effect.

The Multiplier Effect

So, what role does MPC play in all of this? The following formula determines the multiplier impact:

Multiplier = 1/(1 - MPC) = 1/MPS

The magnitude of the multiplier impact is determined by the marginal propensity to consume. In other words, if a person's marginal propensity to consume is large, the economic impact of initial investment will be more significant.

For instance, if the government spends $20 million on the economy, that money will go to the employees of a company. The money can then be spent or saved by those employees. However, the money is spent elsewhere if they have a high predisposition for consumption. 

As a result, those employees have the option to save or spend that money.

We have a domino effect that boosts the economy as a whole, but it is contingent on people's willingness to spend. To put it another way, their marginal propensity for consumption.

As a result, the larger the economic impact of the original government investment, the more likely people to spend.

Economists can use the MPC to predict the overall impact of a future increase in earnings if they can estimate it. The larger the multiplier—the greater the rise in consumption due to increased investment—the higher the MPC.

Factors Affecting Marginal Propensity to Consume

 The factors affecting the changes in the consumption level are:

1. Different Income Levels

People with limited income have a stronger predisposition to consume. This is because they must spend a larger amount of their money on needs. For example, food, power, and rent are all needs that can consume a large percentage of their earnings.

People spend a smaller proportion of their money when their income rises because they are already pleased with their commodities. So, while more is spent on luxuries, the incentive to spend additional income is lower as it is not necessary for survival.

2. Income Increase Type

If the new income is a one-time event, some recipients may perceive it differently because the benefit is just brief. Some people may be tempted to spend the entire $2000 as soon as it arrives in their bank account, while others may be more motivated to preserve it.

We also have more pervasive income gains, which are mainly wage increases. A $2,000 increase over the course of a year, which works out to $167 per month, may not even have an impact on customer behavior in this case. Many people may be unaware of it.

3. Interest Rates

People are more likely to save when interest rates are higher since they can postpone gratification and acquire more items later. Borrowing becomes cheaper at lower interest rates, increasing the incentive to spend while decreasing the motivation to conserve.

When the choice is between earning 1 percent interest or purchasing a new car, the choice is clear.

Earning 10% interest, on the other hand, makes the decision more difficult. The reason for this is that the opportunity cost is higher. For example, if the two options are spending $20,000 on a car or earning interest, the interest would be $200 at a 1 percent rate. 

At 10%, however, the interest is $2,000, implying that the purchaser must forgo a substantially larger portion of their income to purchase the car.

People are more willing to spend when interest rates are low, increasing their MPC.

4. Related to customer satisfaction

People are more prone to save during recessions or uncertain times because they fear losing their jobs. If this happens, they may lose their home and be unable to sustain their family. So people react by putting money aside to weather the storm.

Simultaneously, when circumstances are good and the economy is booming, individuals become more confident and spend more.

5. Inflation

When there is a lot of inflation, goods can quickly increase in price. Therefore, it might create a sense of urgency among customers who want to get their hands on the goods before it increases in price again.

Deflation, on the other hand, is related to lower prices. It encourages people to save instead than consume because future prices will be cheaper.

6. Individual Preferences

When it comes to money, everyone is different. Some people are more conservative and want to conserve money, while others are highly extravagant. 

This can happen at any level, from personal to national. Japan, for example, is recognized for its high savings rate, whereas the United States has a greater consumption rate.

Researched and authored by Rhea Rose Kappan | LinkedIn

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