Marginal Propensity to Consume

Consumption's sensitivity to income and the Multiplier Effecr

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 similarly 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 would 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. These 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 that the initial wage hike at the business causes a chain reaction. It 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 resources:

• Macrofinance
• Economic Exposure
• Purchasing Power Parity
• Supply and Demand

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