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Marginal Propensity to Consume (MPC) is a key concept in economics that helps us understand how changes in income affect aggregate expenditure, the total spending on goods and services in an economy. It essentially measures the portion of additional disposable income that households choose to spend on goods and services rather than saving them. This seemingly simple concept plays a crucial role in economic growth, and understanding MPC is essential to explain why consumer spending has a significant impact on economic growth.
By understanding MPC, economists can predict how changes in income, like tax cuts or wage increases, will influence aggregate expenditure. A higher MPC means a larger portion of additional income will be spent, stimulating economic activity. Conversely, a lower MPC suggests a larger portion will be saved, potentially hindering growth.
What is the marginal propensity to consume?
The Marginal Propensity to Consume (MPC) is a concept in economics that captures how much additional disposable income households decide to spend on goods and services rather than saving it. Imagine you receive a raise or a bonus – the MPC tells us what portion of that extra money you’d likely spend on things you want or need, like groceries, clothes, or entertainment. The MPC is calculated by dividing the change in your consumption expenditure (how much more you spend) by the change in your disposable income (the extra money you receive).
The MPC is crucial because it directly connects changes in income to consumer spending. When households have more disposable income (thanks to a raise, tax cut, or economic boom), a higher MPC translates to a larger increase in spending.
This increased spending by consumers ripples through the economy. Businesses see a rise in demand for their products, which can lead to increased production, hiring, and overall economic growth. Conversely, a low MPC means a smaller portion of additional income gets spent, potentially slowing economic growth.
The MPC is a value between 0 and 1. Here’s what the extremes represent:
- MPC of 0: This indicates that all additional disposable income is saved. In simpler terms, if someone receives extra money, they wouldn’t spend any of it and would choose to save everything.
- MPC of 1: This represents the opposite scenario, where all additional disposable income is spent. If someone receives extra money, they’d use it all on consumption, leaving nothing saved.
In reality, MPC falls somewhere between these two extremes. Most households choose to do some of both – spending a portion of their extra income and saving the rest. The specific value of an MPC depends on various factors, which we’ll explore in a later section.
Formula and Example calculation
Economists divide household expenditure into two main categories: consumption and savings. This means that all the money a household receives (disposable income) is either spent on goods and services (consumption) or saved for future use.
- Consumption = Disposable income – Savings
This equation highlights why the Marginal Propensity to Consume (MPC) value must fall between 0 and 1. An MPC of 0 indicates that all additional disposable income is saved (no spending on consumption). Conversely, an MPC of 1 signifies that all extra income is spent, with nothing left for savings.
We can calculate MPC by dividing the change in consumption expenditure (the additional amount spent) by the change in disposable income (the extra money received). There’s another way to express MPC:
- MPC = Change in consumption expenditure/Change in disposable income
Or
- MPC = 1 – Marginal propensity to save (MPS)
This formula highlights the connection between MPC and MPS (Marginal Propensity to Save). A higher MPC translates to a lower MPS, and vice versa. For example, if a household earns an additional $100,000, spends $60,000 on goods, and saves $40,000, then its MPC is 0.6 (60,000 divided by 100,000), while its MPS is 0.4 (40,000 divided by 100,000).
Why the marginal propensity to consume matters
MPC is essential in analyzing the impact of consumption on the economy. Consumption increases when disposable income increases. Overall, how big the effect of increased disposable income on household consumption will depend on the MPC.
High-income households usually have lower MPCs. When their income rises, they will save more, for example, by investing it in stocks or debt securities. The reason is that with their existing income, they have been able to meet their needs and already have most of the goods they want.
In contrast, MPC is usually high for low-income households. When they get extra income, they tend to devote more portions to subsistence consumption.
The economic multiplier effect
Keynesian uses the marginal propensity to consume concept to explain the multiplier effect of consumption on the economy. Keynesian argues that fiscal policy, such as government spending, creates multiple effects and can lead to higher real GDP growth.
For example, when the government increases spending, such as for railroad projects, it increases demand for goods and services, such as steel. Businesses respond by increasing their output and employing more workers to increase production.
Business activity strengthened, and job creation increased. A more favorable business situation will improve the outlook for household income, and many households will then spend more on goods and services.
Strong consumer spending will require additional production. Once again, businesses will increase their output to meet the extra demand. Companies, of course, employ more workers to increase production. As household income increases, households spend more on goods and services. The process continues and creates a multiplier on output and income.
Similar effects apply to tax policy. When governments lower tax rates, households have more money to spend on goods and services (disposable income increases). Higher demand for products will stimulate businesses to increase output and hire more workers.
The size of the multiplier depends on how much the household spends additional income on goods and services (or the marginal propensity to consume). The higher the marginal propensity to consume, the greater the multiplier effect. Keynes then formulates the multiplier effect of consumption as follows:
- Keynesian multiplier = 1/(1-MPC)
Determinants of marginal propensity to consume
The Marginal Propensity to Consume (MPC) tells us how much extra income households spend on goods and services rather than saving them. But what factors influence this decision? Here’s a breakdown of some key determinants of MPC:
Disposable income: This is the money left after taxes. It’s no surprise that higher disposable income generally leads to higher MPC. With more money available, households feel more comfortable spending a larger portion of their income. Conversely, when taxes rise or income falls, disposable income shrinks, potentially leading to a lower MPC as households prioritize saving for necessities.
Income levels: In general, higher-income earners tend to have a lower MPC. They might already have their basic needs met and have more financial security, allowing them to save a larger portion of their income. Lower-income households, on the other hand, often spend a larger share of their income on essential goods and services, resulting in a potentially higher MPC.
Credit availability and interest rates: Access to credit, like loans, can influence spending decisions. When credit is readily available, and interest rates are low, it can incentivize households to borrow for bigger purchases, potentially increasing their MPC. Conversely, high interest rates or tighter credit restrictions might make borrowing more expensive, leading households to be more cautious about spending and potentially lowering their MPC.
Consumer confidence: People’s outlook on the future plays a role in their spending habits. If consumers are optimistic about job security and future income growth, they might be more likely to spend now, leading to a higher MPC. Conversely, during economic downturns or periods of uncertainty, consumers might become pessimistic and choose to save more for a potential financial buffer, potentially lowering their MPC.
Wealth: The overall wealth of a household can also influence MPC. Wealthier households might have a larger financial cushion, allowing them to spend a smaller portion of their current income and have a lower MPC. However, this doesn’t always hold true, as some wealthy individuals might still choose to spend a significant portion of their income.
