Marginal propensity to consume (MPC)

  • 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

mpc

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

mpc-consumption-function

Average propensity to consume (APC)

apc

The average propensity to consume = consumption / income

Factors that determine the marginal propensity to consume

  • 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:

  1. Saving – marginal propensity to save (mps)
  2. Imports – marginal propensity to spend on imports (mpm)
  3. 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.

multiplier-formula

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

Marginal propensity to save

mps-definition

The marginal propensity to save (MPS) = the amount of extra income that is saved.

In a closed economy (without taxes). The mpc + mps = 1.

Related pages

Published December 7, 2017 | Tejvan Pettinger

29 thoughts on “Marginal propensity to consume (MPC)”

    • Because people are not spending they are saving which does not grow the economy in the short run by less consumer spending will have an effect on investment from businesses to have low confidence which all contribute to AD (C+I+G).

      Reply
  1. this is because of paradox of thrift…. bcz if everyone starts saving especially during depression or recession…. it will decrease the consumption or mpc demand. . due to which aggregate demand will decrease and thru working of multiplier it will decrease national income and obviously gdp

    Reply
    • MPC is the measure of the proportion of extra income that is spent on consumption. When MPC is 1, the households spend all the marginal income, it cannot exceed one as you cannot spend 6 pounds more when there is only a increase of 5 pounds

      Reply
  2. What effect will the following have on MPC. (a) The rate of income tax rises. (b) The economy begins to recover from recession.(c) People anticipates that the rate of inflation is about to rise? (d) The government redistribute income from the rich to the poor. In this case sketch what would happen to the consumption function

    Reply
    • Answer 4, if the lower income households receive more income, their MPC will likely tend toward 1 as they are poor and could want to spend the money on goods that they want, hence (a) stays the same, and b increase which will lead to increase gradient and upward slope curve.

      Reply
  3. Answer 1, in order for a household to keep a pile of wealth, an increase in income tax will decrease the marginal income, so the household may want to save the extra income rather than spending it as income tax took a proportion off it. Answer 2, as a recovery from a recession goes, it may increase average confidence in the economy, and hence MPC increase, but as average price level increase due to increased demand, real income may then decrease and MPC will decrease too. Answer 3, if there’s anticipation of an increase in inflation, confidence decrease and MPC decrease and savings increase. However, most households wouldn’t anticipate an increase in inflation.

    Reply
  4. Actually, a better answer to your first question is that if the rate of income tax increase. Then any more income received will be taxed too(MPT will increase) and hence MPW increase and MPC decreases

    Reply

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