Who has a high marginal propensity to consume?

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Factors that determine the marginal propensity to consume (MPC)
Marginal propensity to consume from gross income
Marginal propensity to consume and the multiplier

Marginal propensity to consume is equal to the change in consumption divided by the change in income. So if income increases by $1 and the consumer spends $0.80, the formula would be 0.8 / 1, which equals 0.8.

If you were to receive a $1,000 bonus this year, you would have $1,000 more than previously – representing a $1,000 change in income. Now suppose you spend $500 of this new income. That represents a $500 change in consumer spending. So the formula would divide the new expenditure ($500) by the new income ($1,000), which equals 500/1,000 = 0.5.

This then leaves us with the marginal propensity to save. If the money is not spent in the economy, it is saved. This is calculated using the formula:

In this case, the marginal propensity to save is the change in consumer saving ($500) divided by the change in income ($1,000), which equals 500/1,000 = 0.5.

If we now look at the diagram for marginal propensity to consume, we can see that there is consumption even when income is zero. This is known as autonomous consumption. People will always need basic necessities such as food and water to survive. So when income is zero, they rely on loans or charity to buy necessities.

As we can see from the diagram above, the marginal propensity to consume can be calculated at any point on the line. So it can be at any point in time across a large range of incomes or income gains.

Income level is an important aspect of the consumer’s propensity to consume. At higher levels of income, consumers are more likely to save. After all, once necessities are accounted for, they have less of a need to spend the additional income.

Let us take an example and say that Company A gives all of its 100 employees a bonus of $1,000 each – worth $100,000. Some of the employees spend $400, some spend $750, and others spend $200 of it. However, on average the 100 employees spend $600 of their bonus.

If we now look at the Marginal Propensity to Consume formula:

The change in income was $1,000 as each employee received this in the form of a bonus. The change in consumer spending, on average, was $600. So the calculation would be 600 divided by 1,000, which equals 0.6.

At low-income levels, people have a higher propensity to consume. This is because they need to spend a greater proportion of their income in order to pay for necessities. Goods such as food, electricity, and rent are all necessities that can take up a high proportion of their incomes.

As incomes increase, people spend a lower proportion of their income as they are already satisfied by the goods they have. Whilst more is spent on luxuries, the incentive to spend additional income is lower as it is not necessary for survival.

If the new income is a one-off, some recipients may treat this in a different way as the gain is temporary. Some may spend the whole lot as they see $1,000 straight into their bank account, whilst others may be more inclined to save.

We also have more permeant income increases – usually an increase in wage. For this type, a $1,000 raise over the year may not even impact consumer behaviour – which would work out as $83 a month. It may go unnoticed by many.

At higher interest rates, there is a greater incentive for people to save – after all, they can delay gratification and receive more goods in the future. However, at lower interest rates, borrowing becomes cheaper, and the incentive to spend increases, whilst the incentive to save decreases.

When faced with the alternative of earning 0.5 percent interest or buying a new car, the decision is that much easier. By contrast, earning 5 percent interest makes the decision more difficult. The reason being is that there is a greater opportunity cost. If the two options are spending $20,000 on a car or earning interest – this would work out at $100 interest when the rate is 0.5 percent. By contrast, at 5 percent, the interest is $1,000 – meaning the consumer has to give up a much larger percentage of their income to buy the car.

So at lower interest rates, people are more likely to spend, thereby increasing the marginal propensity to consume.

During recessionary periods or times of uncertainty, people are more likely to save in fear they may lose their jobs. In such an event, they may lose their house and have no income to support their family. People react by saving in order to weather the potential storm.

At the same time, when times are good and the economy is booming, people feel more confident and increase their spending.

At high levels of inflation, goods can be increasing in price rapidly. This can create a level of urgency among consumers that want to get the product before it goes up in price again.

By contrast, deflation is associated with prices that are falling. This encourages people to delay consumption and instead save as prices will be lower in the future.

Everyone is different when it comes to spending money. Some are more conservative and generally like to save, whilst others are very frivolous. This can extend from a personal level to a national level. For instance, Japan is known for its high savings rate, whilst countries such as the US and the UK have a higher consumption rate.

The multiplier effect is where an initial injection into the circular flow of income can create a multiplying effect. In other words, an investment of $10 million by the government can lead to a $30 million stimulus to the economy. This is because the initial investment trades hands more than once, thereby stimulating demand for more and more products, contributing to a domino effect.

So where does marginal propensity to consume come in? Well the multiplier effect is calculated using the formula:

The marginal propensity to consume determines the extent of the multiplier effect. In other words, a higher marginal propensity to consume will increase the economic effect of an initial investment.

For example, if the government invests $10 million in the economy, that money goes towards a business’s employees. Those employees can then choose to spend or save that money. If they have a high propensity to consume, it is spent at another business. In turn, those employees also can save or spend that money.

What we have is a domino effect that stimulates the wider economy – but is dependent on people’s willingness to spend. In other words, their marginal propensity to consume.

So the more willing people are to spend, the greater economic affect the initial government investment will have.

The marginal propensity to consume (MPC) measures the proportion of extra income that is spent on consumption.
For example, if an individual gains an extra £10, and spends £7.50, then the marginal propensity to consume will be £7.5/10 = 0.75.

The MPC will invariably be between 0 and 1.

The marginal propensity to consume measures the change in consumption/change in disposable income

The marginal propensity to consume can also be shown by the slope of the consumption function:

Average propensity to consume (APC)

The average propensity to consume = consumption / income

Factors that determine the marginal propensity to consume (MPC)

Income levels. At low-income levels, an increase in income is likely to see a high marginal propensity to consume; this is because people on low incomes have many goods/services they need to buy. However, at higher income levels, people tend to have a greater preference to save because they have most goods they need already.
Temporary/permanent. If people receive a bonus, then they may be more inclined to save this temporary rise in income. However, if they gain a permanent increase in income, they may have greater confidence to spend it.
Interest rates. A higher interest rate may encourage saving rather than consumption; however, the effect is fairly limited because higher interest rates also increase income from saving, reducing the need to save.
Consumer confidence. If confidence is high, this will encourage people to spend. If people are pessimistic (e.g. expect unemployment/recession) then they will tend to delay spending decisions and there will be a low MPC.

Marginal propensity to consume greater than one

It is possible that consumers could have a marginal propensity to consume of greater than. If income increases £10, in certain circumstances, they may increase spending by £11 – they finance this extra spending by borrowing. More likely is a fall in income of £10, doesn’t cause a fall in spending because people need to maintain certain spending patterns (known as autonomous consumption).

Marginal propensity to consume from gross income

If a worker gains an extra £100, what will be the marginal propensity to consume on UK goods?

There will be three factors (known as withdrawals) which limit the marginal propensity to consume on domestic goods:

Saving – marginal propensity to save (mps)
Imports – marginal propensity to spend on imports (mpm)
Tax – the tax burden – income tax, consumption tax (mpt)

These three withdrawals can limit the marginal propensity to consume.

Marginal propensity to consume and the multiplier

The multiplier effect states that an injection into the circular flow (e.g. government spending or investment) can lead to a bigger final increase in real GDP. This is because the initial injection leads to knock on effects and further rounds of spending.

The marginal propensity to consume will determine the size of the multiplier. The higher the MPC, the greater the multiplier effect will be. If the marginal propensity to consume is 0, there will be no multiplier effect.

The multiplier (k) = 1/1-mpc

For example, if the government pursues expansionary fiscal policy (higher G) but consumer confidence is very low, then there will be a high propensity to save and a low marginal propensity to consume; this will limit the effectiveness of fiscal policy because the injection will lead to only limited increases in spending and aggregate demand.

Marginal propensity to consume and tax cuts

One important issue regarding MPC is the impact of tax cuts. If the government wished to pursue expansionary fiscal policy, they may cut the higher rate of income tax (45% on income over £150,000). However, the mpc is likely to be low at this income level. However, if the income tax threshold is increased, there is likely to be a greater economic stimulus because, at those income levels, the MPC is higher.

See: best form of economic stimulus