Marginal Propensity to Consume

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Definition of Marginal Propensity To Consume:

The marginal propensity to consume (MPC) is the proportion of the next dollar received that a consumer would spend. For example, if a consumer receives a government check for $100 and spends $70, his marginal propensity to consume is 0.70, or 70 percent.

Detailed Explanation:

Economists use the word “margin” to refer to the next unit of something. Marginal cost is a supplier’s cost to provide one more unit of a good or service. The marginal propensity to consume (MPC) measures the portion of added disposable income a household would spend on consumer goods. It is calculated using the following formula: 

MPC = Change in Consumer Spending
                  Change in Disposable Income

Whatever is not spent must be saved, so the marginal propensity to save equals:

MPS = 1 - MPC

Individuals have different marginal propensities to consume, and an individual’s marginal propensity to consume may change. What factors contribute to your marginal propensity to consume?

Income:
Generally, households with a higher income have a lower marginal propensity to consume. Wealthier families have satisfied most of their consumer needs and tend to save or invest more. Assume you have just graduated from college and moved into your first apartment. Your salary equals $35,000. You barely earn enough to pay your monthly bills. Your boss gives you a $2,000 bonus. Chances are good that you will use your bonus to purchase items you need. Perhaps you will upgrade your wardrobe or purchase an appliance.

Let’s fast-forward 16 years. You have prospered and are well-established. You and your spouse have two children approaching college age. Your combined income is $150,000. Your boss gives you a bonus. There is a good chance you will place a higher percentage of your bonus in savings since your consumer needs are not as urgent as when you were younger.

Consumer Confidence:
Times are great and your company is thriving. It has just landed a large contract with a company in Romania. You anticipate receiving a large raise soon. Your positive outlook may induce you to purchase a new car, or take an exotic family vacation. 

Now let’s assume that the economy enters a recession. The Romanian company withdraws its contract and you become concerned your company will begin laying off people in your department. It is more likely that you will put off buying a new car or plan a vacation closer to home until you learn your job status.

Confidence in the future affects the marginal propensity to consume. Households spend more when they feel confident. They save more when they fear the future. 

Short-term or Permanent Change:
Would you behave differently if you received one big check of $12,000 or if you received a raise of $1,000 per month? Chances are you may pay down your mortgage or invest in stock with a $12,000 check. These are considered forms of saving since savings is money left over after purchasing consumer goods.

Would you place $1,000 more in savings each month if you received a $1,000 pay raise? Most people would not. They would indulge a bit. The marginal propensity to consume is lower when the added disposable income is received as a lump sum. 

Opportunity Cost:
Consumers normally save or invest more when provided an investment earning a higher return. The opportunity cost of consumer spending is higher. For example, if you received a bonus, would you deposit more in savings if the bank paid 2 percent or 10 percent? Chances are you would deposit more in savings when the rate is 10 percent. A household’s MPC is lower when the expected return is higher.

Fiscal Multiplier Effect:

The MPC determines the fiscal policy multiplier, which economists use to estimate how much a tax cut or spending increase will increase the economy’s aggregate demand. An economic stimulus – such as a tax cut or spending increase – has a greater impact on the aggregate demand when the MPC is higher. More of the stimulus is returning to the economy through consumer spending. The formula for the fiscal multiplier is:

Fiscal Multiplier = 1 / (1 - MPC)

In 2008, at the beginning of the Great Recession, President George W. Bush attempted to stimulate the economy by providing a rebate. The National Bureau of Economic Research reported, “Of those households receiving the rebate, almost 20 percent reported that they would spend it; nearly 32 percent reported that they would mostly save the rebate, and 48 percent reported that they would mostly pay debt with the rebate." The authors concluded that there was a “low bang for the buck” because the rebate did not stimulate the economy as much as expected. Why? First, the rebate was made when most consumers were fearful of the economy’s direction. Consumer confidence was low, so many used the rebate to pay down debts or deposit it in savings. Second, the rebate was a one-time payment.

Dig Deeper With These Free Lessons:

Fiscal Policy – Managing an Economy by Taxing and Spending
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Marginal Analysis – How Decisions are Made