What Is Marginal Propensity To Consume (MPC)?
In economics, the marginal propensity to consume (MPC) is defined as the proportion of an aggregate raise in pay that a consumer spends on the consumption of goods and services, as opposed to saving it. Marginal propensity to consume is a component of Keynesian macroeconomic theory and is calculated as the change in consumption divided by the change in income. MPC is depicted by a consumption line, which is a sloped line created by plotting the change in consumption on the vertical "y" axis and the change in income on the horizontal "x" axis.
Types of MPC
MPC greater than 1
When we observe an MPC that is greater than one, it means that changes in income levels lead to proportionately larger changes in the consumption of a particular good. It can sometimes be correlated to goods with price elasticities of demand that are greater than 1, as demand for such goods would change by a disproportionately large factor when prices change. These goods are thought to be non-essential or “luxury goods,” as demand for these goods is more volatile than demand for essential goods and services.
MPC equal to 1
When we observe an MPC that is equal to one, it means that changes in income levels lead to proportionate changes in the consumption of a particular good. It can sometimes be correlated to goods with price elasticities of demand that are equal to 1, as demand for such goods tends to change in a linear fashion when prices change. These goods are fairly rare to observe in real-life economies.
MPC less than 1
When we observe an MPC that is less than one, it means that changes in income levels lead to proportionately smaller changes in the consumption of a particular good. It can sometimes be correlated to goods with price elasticities of demand that are less than 1, as demand for such goods would change by a disproportionately smaller factor when prices change. The goods are thought to be essential; as demand for these goods is less volatile than demand for non-essential goods and services.
Marginal propensity to save (MPS)
Marginal propensity to save (MPS) refers to the proportion of any extra income that is saved by consumers.
For an individual, the marginal propensity to save will reflect how much they want to put extra income into different forms of saving.
For example, if a worker receives a pay rise of £1,000 and they add an extra £350 to their savings. Their MPs will be 0.35.
Marginal propensity to save can also refer to the whole economy. If national income rises £2 bn, and national savings increase by £0.1 bn. The marginal propensity to save is 0.05.
Saving function
a = autonomous consumption. In this case -a = autonomous saving. At zero income, households borrow to afford the basic necessities of life.
MPS = slope of the savings function. In this case it is -1 + (1-b)Y
How to calculate the MPS
If the change in income = 8% and saving rises 2%. The MPS = 0.25
Why is MPS + MPC always equal to one?
If we ignore taxes and imports, i.e. assume a closed economy. Eith we send money or save it. If we gain an extra £10, and spend £8, by definition the extra £2 is saved.
MPS = 1-MPC
The marginal propensity to save is related to the marginal propensity to consume. Ignoring taxes and imports, the marginal propensity to save (MPS) = 1-mpc
Factors that influence the marginal propensity to save MPS
Income levels. At low-income levels, consumers will be buying all the necessities of life. An increase in income, will probably all be spent. At higher income levels, with all necessities bought, saving becomes an affordable extra.
The diminishing marginal utility of income. As income levels rise, extra income has a diminishing utility and so consumers may not know what to spend the money on and therefore spend an increasing percentage. The Keynesian consumption function shows that the marginal propensity to consume falls at higher incomes – meaning the marginal propensity to save rises.
Life-cycle hypothesis. Theories of life-cycle spending assume individuals wish to smooth out their consumption over a period of time. During a period of studying, the marginal propensity to save will be zero (students probably will borrow. As they get a better-paid job and pay off their debts, they will be in a position to increase their savings. During their mid-working life, individuals will tend to have a higher propensity to save – as they put money aside for retirement.
Individual preferences. Not all individuals are rational. Approx 25% of individuals do not follow the life-cycle hypothesis models and may fail to save, when rational utility maximization may suggest they should. Some individuals are more prone to present-income bias. This means individuals place a higher weight on consumption in the present moment than saving for the future.
Risk-averse – risk-loving. Some individuals are risk-averse, and therefore are more likely to save extra income – planning for unemployment e.t.c. Risk-loving individuals may not wish to save.
Importance of marginal propensity to save
Influences the size of the multiplier. A high marginal propensity to save will lead to a smaller multiplier effect. With a high MPS, extra income does not ‘trickle down to other elements of the economy but gets saved. It reduces the effectiveness of fiscal policy
The marginal propensity to withdraw MPW is the extra income that is withdrawn from the circular flow. Withdrawals = saving, import, and tax.
Example
Suppose the marginal propensity to save = 0.25. In this case, the multiplier is 1/0.25 = 4
If the marginal propensity to save rises to 0.6. In this case, the multiplier is 1/0.6= 1.66