The more money people have, the more they often spend. Economists call this increase the marginal propensity to consume. This formula divides the increased income into the increased spending. The resulting number gives the MPC quotient. MPC helps predict the impact of lower taxes or higher spending.
Marginal propensity to consume is an economic term describing something most people know from experience: If you have more money, you spend more money. The marginal propensity to consume formula turns this tendency into a number. If you spend 30 percent of every pay increase and save the rest, your MPC total is .3.
The MPC Formula
The MPC equation is one of the easier economic formulas to use. Suppose you get an increase in your income and spend some of the extra money. Divide the increased spending by the increased income and you have your MPC.
For example, suppose you get a raise that gives you $3,000 more annual income. If you spend half of the raise, your MPC is $1,500/$3,000 or 0.5. If you spend all of the increase, the MPC formula says your MPC is 1. If you save the entire $3,000, you have a zero MPC. You won't need a marginal propensity to consume calculator to figure it all out.
MPC normally falls between zero and 1. However, it's at least theoretically possible to have an MPC greater than one. This happens if, say, your income grows by $3,000 and you increase spending by $4,000, giving you a 1.33 MPC.
Understanding MPC Economics
Economists not only crunch a lot of numbers, but they also try to understand why the numbers fall out the way they do. In studying marginal propensity to consume, they've identified several factors that influence it.
- Income levels. MPC is higher for people who have lower incomes. An extra $1,000 to someone working minimum wage is a big deal, but it's not even 1 percent of a millionaire's income. A millionaire who has already bought everything they want may just stick the extra money in the bank. A minimum wage worker probably has purchases they really need to make.
- Temporary or Permanent? A worker who receives a $1,000 bonus is more likely to save it than if it's a $1,000 raise. Raises are permanent, so employees have more confidence in spending them.
- Interest rates. If interest rates go up, putting the extra money in the bank makes more sense than if rates are flatlining. Rising interest rates earn people more money, though, so they may end up spending that and increasing their MPC down the road.
- Consumer confidence. If people see the economy as full of promise, they figure it's safe to spend more. If they worry about a recession or losing their job, the pressure is on to save.
The MPC Multiplier
Economists use the MPC equation to track how the effects of increased income ripple and multiply as they pass through the economy. Suppose that to retain your workforce, you increase wages 20 percent across the board. Your staff's marginal propensity to consume is 0.5, meaning they spend half of the income boost.
The result? The businesses they patronize with the extra money see a boost in their income, too. Those companies can spend the added money buying new office equipment or extra goods to sell. The vendors they buy from have more money, so they also spend more money. In this fashion, a small MPC can lift everyone's boats.
But how much of a lift? The multiplier equals 1 divided by 1 - MPC. If the MPC is .5, then the multiplier effect on the economy is 2. If people save all their extra income, the multiplier is 1/1 - 0, which equals 1. There's no multiplier to lift the boats.
The Role of Government
Changes to tax rates can complicate the MPC equation by changing consumer behavior. Lowering taxes increases people's after-tax income. That can trigger the marginal propensity to consume. This is more effective if taxes drop on lower-income workers than on people with high incomes. The effects of the tax change can also be affected by consumer confidence. If people expect a recession, they may save their bigger tax refunds rather than spending them.