MPC Formula, MPC Meaning and Example
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MPC meaning: It is the change in consumer spending caused by disposable income change. The name ‘marginal’ is used to mean additional. This guide takes you through the MPC formula and examples.
Don’t get this confused; disposable income does not always increase. It can increase or decrease depending on several factors. However, Marginal Propensity to Consume focuses on increased disposable income.
The formula for Marginal Propensity to Consume (MPC) is expressed as ΔC / ΔY.
C = Consumption function
Y = Change in disposable income
Note: the change in disposable income accounted for is the change in disposable that had caused the change in consumption.
MPC Formula = ΔC / ΔY.
Example: Mark played a lottery and won $1,000. After the tax was deducted, he remained with $900. He decided to spend $630 of the $900. The Marginal Propensity to Consume for Mark is calculated as follows:
Disposable Income Y = $900
Amount Spent C = $630
MPC = ΔC / ΔY
MPC = $630 / $900
MPC = 0.7 or 70%
It’s simple, after Mark deducted tax, he remained with $900. This is the disposable income that he has to decide how to spend.
He spends $630, which is a positive change in his consumption function.
How do you Interpret Marginal Propensity to Consume?
Marginal Propensity to Consume is expressed as a percentage of the total disposable income. If this percentage is below 1 (MPC<1), the consumer did not spend every penny of disposable income, like in the above example. Some amount was saved, as is the other only viable alternative.
What does a marginal propensity to consume equal to 1 mean?
If the MPC equals 1 (MPC=1), the consumer spent each penny of their increased disposable income. There was no amount of disposable income saved by the consumer.
Why does MPC lie between 0 and 1?
Marginal propensity to consume is between 0 to 1 because it only accounts for disposable income and ignores loans and other forms of borrowing. MPC accounts for what consumer has spent from their disposable income. It does not account for credit purchases or money borrowed for transactions motives.
The disposable income accounted for can be spent in its entirety or a percentage of it. When the whole disposable income is spent, this is an MPC of 100% (1). Where a percentage of disposable income spent is 50%, this is 0.5 MPC. When the entire disposable income is saved, this is 0% or MPC of 0.
What Happens When MPC Increases?
This can be addressed from an individual consumer perspective and the entire economy perspective.
When the MPC of an individual consumer increases, they save less of their disposable income. Take, for instance, a consumer whose MPC has increased from 0.6 to 0.8. When the MPC was at 0.6, this consumer saved 0.4 of their increased disposable income.
The new MPC of 0.8 means that the consumer is saving only 0.2 of their increased disposable income.
When most consumers in an economy increase their MPC, they save less and spend more. The rate of currency exchange increases, and so is economic activity. In an economy where consumers have high MPC, it implies consumers do not hold on to so much money for speculative motives.
What Factors Affect Marginal Propensity to Consume?
1. Government expenditure
Increased government expenditure through subsidies and incentives stimulates demand. This is because it results to lower prices of goods and services. Consumers will often maximize their spending to take advantage of the lower costs. In an attempt to take advantage of the lower prices, consumers increase their MPC.
If the government reduces its expenditure, the costs of production go high. The high cost of production is extended to the prices of goods and services. As the prices of goods and services shoot, customers ration their demands through opportunity costs. This lowers the amount spent on commodities from disposable income and hence lower MPC.
2. Deflation and Inflation
During deflation, prices of goods and services generally reduce in the market. At a constant income level, the value of money increases as consumers can consume more and pay less. With the hope of a further decrease in prices, consumers hold on to money with speculative motives. The more people save, the lower the MPC.
During inflation, peoples start to feel the pinch of shooting prices of goods and services. People buy as soon as they get the money to avoid delays in purchases, only to pay higher in the future. Consumers use their disposable income for their transactions motives and spend most of it. The increased spending during inflation increases MPC.
High taxes increase the prices of goods and services. With a constant disposable income, people must pay more for necessities. Even at constant consumption levels, the amount spends on consumption increases. Therefore, increased taxes result in a higher MPC.
Where taxes are low, prices of goods and services reduce. Consumers incur less on consumption in comparison to when the prices of commodities were high. They are left with more money to save and hence reduced MPC.
4. Level of Income
Low-income earners have less money to spend on many necessities. Their MPC is usually high because a saving option is less viable to them. To some, they live from hand to mount, and their MPC can be as high as 1.
Unlike low-income earners, high-income earners can spend their money on necessities to their satisfaction. More money is left for them to save on speculative or precautionary motives. This is why high-income earner has lower MPC.
5. Money motives
Regardless of the other factors mentioned above, money motives differ from one consumer to another. A consumer with transaction money motives will spend most of their money. To such consumers, their transactions money motives will increase their MPC.
Consumer cautious about their future earnings will spend their money with precautions. They will therefore hold on to money for precautionary motives. These precaution money motives will discourage spending and reduce MPC.
A consumer with a speculative motive will hold on to money not because they are uncertain about their future earnings. Such consumers spend less of their disposable income to save as much as possible. Saving is with speculations of pursuing certain opportunities they are optimistic about. Thus, speculative motives of money results in reduced MPC.
MPC and MPS
For the saved amount, it is computed under Marginal Propensity to Save. This is because, for any penny of increased income, a consumer is limited to two alternatives, spend or save. If consumers decide to spend, they can spend the entire amount or a certain percentage. In case of a choice to save, the entire amount could be saved or a given percentage.