Marginal Propensity to Consume

What is the Marginal Propensity to Consume?

The Marginal Propensity to Consume (MPC) refers to how sensitive consumption in a given economy is to unitized changes in income levels. MPC as a concept works similar to Price Elasticity, where novel insights can be drawn by looking at the magnitude of change in consumption as a result of income fluctuations.

To calculate MPC, we can use the following equation:

Where:

• Change in consumption – Refers to the change in consumption (of a good, service, or general consumption in an economy) resulting from changes in income, expressed in percentage terms.
• Change in income – Refers to the change in income levels of consumers, expressed in percentage terms.

MPC is expressed as an absolute value.

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.

The Multiplier Effect

The multiplier effect occurs as a result of small changes in income levels that are created by either governments or private enterprises. Suppose that a business raises wages for its employees by 20%. Thus, the employees will have 20% more income to purchase a variety of goods and services.

Suppose that all the employees at this company decided to spend the additional money on a good with a historical MPC of 0.5. In this case, we can rearrange the MPC equation and solve for the % change in consumption – which will be a 10% increase.

Now, the beneficiaries of this increase in consumption (namely the suppliers of the good) will also have an additional 10% to spend on goods and services that can boost their utility. Suppose that the suppliers choose to spend the additional revenues on a good with an MPC of 1.5. In this case, we can rearrange the MPC equation and solve for the percent change in consumption – which will be a 15% increase.

Thus, the cycle repeats itself and the initial wage hike at the business causes a chain reaction. This is known as the “multiplier effect,” and is a reminder that even small changes can have major consequences.

More Resources

Thank you for reading this CFI article. CFI offers the Financial Modeling & Valuation Analyst (FMVA)® certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following CFI resources:

• Autonomous Consumption
• Macrofinance
• Economic Exposure
• Purchasing Power Parity
• See all economics resources