What is the Marginal Propensity to Consume?

The marginal propensity to consume, also known simply as MPC, is an economic theory that measures the relationship between an increase in pay and the consumption of goods and services. The idea is to determine what proportion of that pay increase will be used for purchasing consumer products and what proportion is likely to be saved. Understanding the marginal propensity to consume is important to the process of evaluating consumer spending habits and determining the impact of those habits on a local or national economy.

One of the easiest ways to understand how a marginal propensity to consume is measured is to consider the example of a household that has recently experienced a pay increase that resulted in additional income of $500 US dollars (USD). If the household chooses to spend half of that amount on a push style lawn mower and place the remainder into a savings account, the marginal propensity to consume is considered to be 0.5. This figure is determined by dividing the amount spend by the total amount received, or $250 USD divided by $500 USD.

Understanding the marginal propensity to consumer is important to individuals and companies for a variety of reasons. Companies want to encourage consumers to spend more of their earnings, specifically in purchasing items made by a given company. In terms of managing their own resources, companies also seek to strike an agreeable balance between what they spend and what they invest in interest bearing accounts or other assets that can be converted into cash quickly if needed. As with households, building up cash reserves while also using income to make wise purchases leads to greater financial stability over the long run.

Governments also consider the marginal propensity to consume when attempting to manage the national economy. For this reason, a government, through its central or federal bank system may increase or lower interest rates as a means of either encouraging companies and households to spend more or to save more, depending on which approach is seen as the most beneficial for the economy. By providing incentives for consumers to spend more, an economy can often be lifted out of a period of recession, since more products sold means more revenue circulating in the economy and supporting the creation of jobs. At the same time, if a government wishes to slow the rate of inflation within an economy, incentives to spend may be withdrawn, encouraging citizens to place more of their additional income into savings rather than making purchases.