The marginal propensity to consume (MPC) is the portion of the additional disposable income that consumers spend on goods and services. We calculate it by dividing the change in consumption expenditure to the change in disposable income.
Formula and example calculation of marginal propensity to consume
Economists divide household expenditure into two, namely consumption and savings. Hence, how much money is spent on consumption? It will equal to disposable income minus the money saved.
Consumption = Disposable income – Savings
For this reason, the MPC value will be between 0 and 1. The MPC value of 0 means all extra income is saved, and 1 means extra income is spent on goods and services.
MPC = Change in consumption expenditure/Change in disposable income
MPC = 1 – Marginal propensity to save (MPS)
For example, if a household earns an additional income of Rp100,000, where Rp60,000 is spent on goods, and Rp40,000 is saved, then MPC is 0.6, while MPS is 0.4.
Why marginal propensity to consume is important
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, with the 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.
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 a higher real GDP growth.
For example, when the government increases spending such as for railroad projects, it causes an increase in demand for goods and services such as steel. Businesses respond to it 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. Many households 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. Household income increase, leading them to spend more on goods and services. The process continues and creates a multiplier on the 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
Many factors determine the marginal propensity to consume, including taxes, income levels, wealth, credit availability, interest rates, prices of goods, and consumer confidence.
Disposable income represents the income left after the household paying the tax. Therefore, the higher the tax rate, the lower is disposable income. If we take into account the tax effects, then we should modify the formula above to:
Keynesian multiplier = 1/[1-MPC(1-tax rate)]
Furthermore, each individual’s consumption expenditure also varies based on their income level. Usually, higher-income individuals are likely to spend less on goods and services than lower-income individuals.
Consumers also rely on credit to buy several goods, such as housing and vehicles. Inevitably, interest rates and credit availability become determinants. High-interest rates make loan costs more expensive; therefore, they tend to delay such purchases. On the other hand, consumers prefer to save because returns are higher when interest rates rise.
Consumer confidence is also the next important factor. If consumers are optimistic about their future income and job, they are likely to shop now. Conversely, when they are pessimistic, they will tend to save more, anticipating adverse conditions in the future.