    # If consumption spending increases by \$750 when disposable income increases by \$1,000 the MPC

Consumption function shows the corresponding values of consumption at various levels of income, by a functional relationship between income & consumption.

Consumption Function = a + b Yd; where Y = Disposable (after tax) Income

a = autonomous consumption, ie consumption at zero level of income

b = marginal propensity to consume, ie ratio showing responsive change in consumption due to change in income. {Formula = Change in Consumption / Change in Income}

• Explain and graph the consumption function
• Explain what would cause the consumption function to grow steeper or flatter, or to shift up or down

Keynes observed that consumption expenditure depends primarily on personal disposable income, i.e. one’s take home pay. Let’s examine this relationship in more detail. People can do two things with their income: they can consume it or they can save it. (For the moment, let’s ignore the need to pay taxes with some of it). Each person who receives a raise in income faces this choice. Let’s define the marginal propensity to consume (MPC) as the share (or percentage) of the additional income a person decides to consume (or spend). Similarly, the marginal propensity to save (MPS) is the share of the additional income the person decides to save. Since the only options are to consume or save income, it must always hold true that:

For example, if the marginal propensity to consume out of the marginal amount of income earned is 0.9, then the marginal propensity to save is 0.1.

With this relationship in mind, consider the relationship among income, consumption, and savings shown in Table 1.

Table 1. The Consumption Function
Income Consumption Savings
\$0 \$600 –\$600
\$1,000 \$1,400 –\$400
\$2,000 \$2,200 –\$200
\$3,000 \$3,000 \$0
\$4,000 \$3,800 \$200
\$5,000 \$4,600 \$400
\$6,000 \$5,400 \$600
\$7,000 \$6,200 \$800
\$8,000 \$7,000 \$1,000
\$9,000 \$7,800 \$1,200

In Table 1, for each increase in income of \$1000, consumption increases by \$800. Thus, the marginal propensity to consumer (MPC) is 0.80. Any additional income which isn’t spent is saved, so for each increase in income of \$1000, saving increases by \$200. The MPS is 0.20.

The pattern of consumption shown in Table 1 is plotted in Figure 1. The relationship between income and consumption, whether in tabular or graphical form is called the consumption function. Both the table and figure illustrate a typical consumption function. There are a couple of features to observe. First, consumption expenditure increases as income does. For every increase in income, consumption increases by the MPC times that increase in income. Thus, the slope of the consumption function is the MPC. Second, at low levels of income, consumption is greater than income. Even if income were zero, people would have to consume something. We call the level of consumption when income is zero autonomous consumption, since it shows the amount of consumption independent of income. In this example, consumption would be \$600 even if income were zero. Thus, to calculate consumption at any level of income, multiply the income level by 0.8, for the marginal propensity to consume, and add \$600, for the amount that would be consumed even if income was zero.

C = 600 + 0.8*Y Figure 1. The Consumption Function. In the expenditure-output model, how does consumption increase with the level of national income? Output on the horizontal axis is conceptually the same as national income, since the value of all final output that is produced and sold must be income to someone, somewhere in the economy. At a national income level of zero, \$600 is consumed. Then, each time income rises by \$1,000, consumption rises by \$800, because in this example, the marginal propensity to consume is 0.8.

A change in the marginal propensity to consume will change the slope of the consumption function. An increase in the MPC steepens the consumption function; a decrease in the MPC flattens it.

A number of factors other than income can also cause the entire consumption function to shift. These factors were summarized in the earlier discussion of consumption. For example, changes in consumer expectations about the future, or changes in household wealth would cause the consumption function to shift up or down to a a new consumption function that is parallel to the original one.

These questions allow you to get as much practice as you need, as you can click the link at the top of the first question (“Try another version of these questions”) to get a new set of questions. Practice until you feel comfortable doing the questions.

These questions allow you to get as much practice as you need, as you can click the link at the top of the first question (“Try another version of these questions”) to get a new set of questions. Practice until you feel comfortable doing the questions.

Did you have an idea for improving this content? We’d love your input.

Marginal propensity to consume (MPC) refers to the proportion of extra income that a person spends instead of saves. The term and its formula are based on observations made by famed British economist John Maynard Keynes in the 1930s during the Great Depression. He noted that individuals have the propensity to consume more when their income increases. MPC is useful because it relates to how a government stimulus might affect the economy.

• Marginal propensity to consume (MPC) measures how much more individuals will spend for every additional dollar of income.
• MPC is calculated as the ratio of marginal consumption to marginal income.
• MPC is related to the so-called Keynesian multiplier, where MPC can help predict the economic growth from a government stimulus.
• The multiplier effect refers to a chain reaction of consumption by various entities brought about by an initial increase in income.
• An MPC of one means a person spent all additional income. An MPC of zero means they spent none of it and, instead, invested it.

The formula used to calculate marginal propensity to consume is change in consumption divided by change in income, or, MPC = ∆C/∆Y. To make this calculation, you first must determine the change in income and the resulting change in spending (consumption). If someone's income increases by \$5,000 and their spending increases by \$4,500, the calculation would be made in this way:

MPC = 4,500/5,000. MPC = .9 or 90%

Keynes formally introduced the concept of MPC in his 1936 book, The General Theory of Employment, Interest, and Money. Keynes argued that all new income must either be spent, as with consumption, or invested, as with savings.

Keynes understood that the classical thinking which held that supply would create its own demand did not always work. He noted that the main problem was a lack of aggregate demand. He believed that government spending could add to aggregate demand and that this fiscal stimulus would create a multiplier effect. This effect would result from increases in income and consumer spending that caused a chain reaction of spending by various other beneficiaries of the spending.

Despite the relative simplicity of Keynes' argument about identifying MPC, macroeconomists have not been able to develop a universally accepted method of measuring MPC in the real economy. Much of the problem is that new income is considered to be, both, a cause and an effect on the relationship between consumption, investment, and new economic activity, which generates new income.

Take an employee of ABC Company. They receive a raise in salary. Their spending goes up as a result. What is MPC in this instance? Since the formula for MPC is change in consumption divided by change in income, you must first determine those two changes.

For change in income, the salary rose from \$65,000 to \$75,000. The change is \$10,000 (\$75,000 minus \$65,000).

For change in consumption, determine levels of spending before and after the salary increase. Before the increase, the employee spent \$60,000 of the \$65,000 on goods and services. They put the remaining \$5,000 into savings. After the salary raise to \$75,000, they spent \$65,000 on goods and services. The change in consumption is \$5,000 (\$65,000 minus \$60,000).

To calculate marginal propensity to consume, insert those changes into the formula:

MPC = ∆C/∆Y

MPC = 5,000/10,000

MPC = .5 or 50%

This means the individual spent 50% of their added income on goods and services.

An MPC equal to one means that a change in income (∆Y) led to the same proportionate change in consumption (∆C). That is, a person spent 100% of the additional income on goods and services and saved none of it.

An MPC less than one means that a change in income produced a proportionally smaller change in consumption. A person spent less than the added income received.

An MPC equal to zero means that a change of income led to no change in consumption. So, a person spent none of the change in income and, instead, put it into savings.

An MPC that is higher than one means that additional income led to spending that surpassed the amount of additional income.

Marginal propensity to consume is a figure that represents the percentage of an increase in income that an individual spends on goods and services.

A high MPC indicates that the proportion of increased income spent on goods and services approached the actual amount of that increase. Conversely, a low MPC means an individual spent less of that increase in income and instead, put the money into savings.

Marginal Propensity to Consume increases when consumption represents more of the amount of the added income rather than less. In other words, a person spends more and saves less. Typically, lower income levels produce a higher MPC than higher income levels. 