Marginal Propensity to Consume

Marginal propensity to consume (MPC) is the proportion of an individual’s additional income which he spends. It is the ratio of change in consumption to change income. It can also be defined as the slope of the consumption function.

You either spend what you earn or save it. What you spend equals what you earn minus what you save. In taking stock of what you consume, it is natural to work out the ratio of your consumption to income. This equals your average propensity to consume. But economists are mostly interested in the marginal analysis i.e. change in your consumption when there is a change in your income. In other words, they want to know if there is any increase in your income how much of it will you spend and how much will you consume. This is estimated by calculating the ratio of increase in consumption to increase in income which equals your marginal propensity to consume.

Calculation

Marginal propensity to consume can be calculated by dividing the increase in consumption (∆C) to increase in disposable income (Y):

$$ MPC=\frac{∆C}{∆Y} $$

MPC can also be calculated as 1 minus your marginal propensity to save (MPS):

$$ MPC=1\ – MPS $$

In practice economists estimate marginal propensity to consume by regression analysis of personal consumption expenditure and disposable income.

Why is MPC important?

Marginal propensity to consume (MPC) is an important number in economist because it tells us about the strength of the multiplier effect. Since what you spend becomes some else’s income, if the marginal propensity to consume is high, any fiscal stimulus i.e. increase in government expenditure or decrease in taxes will have a more pronounced effect of total income.

MPC is related to the fiscal multiplier as follows:

$$ Multiplier\ =\ \frac{1}{1-MPC} $$

For example, if people in an economy consume 80% of their disposable income on average, multiplier is 5. It means that a $1 of fiscal stimulus should increase total income by $5.

Marginal propensity to consume also features in the Keynesian consumption function shown below:

$$ C\ =\ c_0+c_1\times Y $$

Marginal propensity to consume (c1) is the slope of the consumption function. The function above tells us that consumption equals autonomous consumption c0 and the product of MPC and disposable income.

Example

Let’s work out MPC in the following three cases: Mark recently received a raise of $500 per month which caused an increase in his spending by $300. Anthony’s consumption function is given by the following equation: C = $2,000 + 0.8 × YD.Tom’s marginal propensity to save (MPS) is 0.25.

Mark’s MPC is the ratio of change in consumption (∆C) to change in income (∆Y):

$$ {\rm MPC}_M=\frac{∆C}{∆Y}=\frac{$300}{$500}=0.6 $$

Anothy’s MPC is 0.8 which is the slope of his consumption function.

Tom’s MPC is 0.75 calculated by subtracting his MPS from 1:

$$ {\rm MPC}_T=\ 1\ -\ MPS\ =\ 1\ -\ 0.25\ =\ 0.75 $$

Written by Obaidullah Jan, ACA, CFA and last modified on