How to Calculate MPC: Marginal Propensity to Consum

Marginal propensity to consume (MPC) refers to the proportion of extra income that a person spends instead of saves. The term and its formula are based on observations made by famed British economist John Maynard Keynes in the 1930s during the Great Depression. He noted that individuals have the propensity or tendency to consume more when their income increases. Marginal propensity to consume is useful because it relates to how a government stimulus might affect the economy.

How to Calculate Marginal Propensity to Consume (MPC)

The formula used to calculate marginal propensity to consume is change in consumption divided by change in income, or, MPC = ∆C/∆Y. To make this calculation, you first must determine the change in income and the resulting change in spending (consumption).

For example, if someone's income increases by $5,000 and their spending increases by $4,500, the calculation would be MPC = 4,500/5,000. For this brief example, the person's MPC would be .9, or 90%.

Origins of Marginal Propensity to Consume

Keynes formally introduced the concept of marginal propensity to consume in his 1936 book "The General Theory of Employment, Interest, and Money." Keynes argued that all new income must either be spent, as with consumption, or invested, as with savings.

Keynes understood that the classical thinking which held that supply would create its own demand did not always work. He noted that the main problem was a lack of aggregate demand. He believed that government spending could add to aggregate demand and that this fiscal stimulus would create a multiplier effect. This effect would result from increases in income and consumer spending that caused a chain reaction of spending by various other beneficiaries of the spending.

Despite the relative simplicity of Keynes' argument about identifying MPC, macroeconomists have not been able to develop a universally accepted method of measuring MPC in the real economy. Much of the problem is that new income is considered to be both a cause and an effect on the relationship between consumption, investment, and new economic activity, which generates new income.

Marginal Propensity to Consume Example

Take an employee of ABC Company. They receive a raise in salary. Their spending goes up as a result. What is MPC in this instance? Since the formula for MPC is change in consumption divided by change in income, you must first determine those two changes.

For change in income, the salary rose from $65,000 to $75,000. The change is $10,000 ($75,000 minus $65,000).

For change in consumption, determine levels of spending before and after the salary increase. Before the increase, the employee spent $60,000 of the $65,000 on goods and services. They put the remaining $5,000 into savings. After the salary raise to $75,000, they spent $65,000 on goods and services. The change in consumption is $5,000 ($65,000 minus $60,000).

To calculate marginal propensity to consume, insert those changes into the formula:

• MPC = ∆C/∆Y
• MPC = 5,000/10,000
• MPC = .5 or 50%

This means that for the given period, the individual spent 50% of their added income on goods and services.

Interpreting Marginal Propensity to Consume

An MPC equal to one means that a change in income (∆Y) led to the same proportionate change in consumption (∆C). That is, a person spent 100% of the additional income on goods and services and saved none of it. There are several broad ways to interpret MPC calculations:

• An MPC less than one means that a change in income produced a proportionally smaller change in consumption. A person spent less than the added income received.
• An MPC equal to zero means that a change of income led to no change in consumption. So, a person spent none of the change in income and, instead, put it into savings.
• An MPC that is higher than one means that additional income led to spending that surpassed the amount of additional income.

Special Considerations When Calculating MPC

When calculating MPC, there's some nuances you should keep in mind. First, think of your time frame. In the short term, individuals may respond differently to changes in income compared to the long term. Short-term windfalls like bonuses or tax refunds often result in higher MPCs as people are more likely to spend this extra income immediately.

MPC may also vary based on income or wealth. Lower-income households typically have a higher MPC because they allocate a larger proportion of their income to basic necessities like food, housing, and healthcare. Higher-income households tend to have a lower MPC as they allocate more of their income to savings, investments, and discretionary spending.

MPC calculations can vary based on debt preference as well. People with high levels of debt may prioritize debt repayment over consumption when they receive additional income. This means people with more debt and prioritize payments have a lower MPC.

As with many economic factors, there are cultural norms and individual behavioral tendencies that influence the MPC. In some cultures, saving may be emphasized over consumption. In other contexts, certain genders may have certain behavioral tendencies. It's important to understand the broader context of who the MPC is being calculated for as any given collection of individuals may lead to varying results for reasons other than economical.

Last, like we'll touch on next, the government can influence MPC. Governments may want to encourage spending or may want to dissuade consumers from spending. Understand broader macroeconomic stances when looking at MPC data, especially over time.

MPC and Economic Policy

MPC plays an important role broader macroeconomic conversations and strategic policy development. During times of economic downturn or recession, the Federal Reserve may initiate quantitative easing to stimulate economic growth by injecting liquidity into the financial system. The expectation is that the lower cost of debt will encourage consumers to spend more, thereby increasing aggregate demand and supporting economic recovery.

Therefore, the effectiveness of government policy in stimulating consumer spending depends partly on the MPC. If households have a high MPC, they are more likely to spend the additional income generated which helps with economic development.

Conversely, if the MPC is low and households choose to save a significant portion of their additional wealth or income, the stimulative effect of monetary policy may be limited. If MPC is low, governments may need to further incentivize consumers to spend in order to stimulate the economy.

The Bottom Line

The marginal propensity to consume is the proportion of added income that is spent vs. that which is saved. To calculate the MPC, you need to know the change in income as well as the change in spending (or consumption). Divide the change in consumption by the change in income to find MPC. The calculation is written like so: MPC = ∆C/∆Y.

Calculating the marginal propensity to consume can show how sensitive households or economies are to increases in income.