Brianna has a masters of education in educational leadership, a DBA business management, and a BS in animal science.
Marginal Propensity to Consume (MPC)
We all would love the opportunity to receive extra money on our paychecks. But what would you do with that extra money? Would you buy new clothes? Would you go to a concert? Or perhaps you would buy the newest cell phone that was just released. While most of us have some sort of routine of what we pay each month with our paychecks, in the event that we do receive extra income, we must make a decision of what to do with that money.
In this lesson we will look at one choice, which is to spend the money on goods and services. How much of that extra money we spend is known as the marginal propensity to consume. In other words, when we receive extra money, the proportion of it that's spent rather than saved falls under marginal propensity to consume.
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- 0:04 Marginal Propensity to…
- 0:43 Formula and Calculations
- 1:25 Multiplier Effect
- 2:23 Additional Formula and…
- 3:05 Lesson Summary
Formula and Calculations
Now that we know what marginal propensity to consume is, let's apply it to an example so that we can see how it's actually calculated.
Let's imagine that you receive a $600 bonus on your paycheck. After discussing it with your family, you decide to purchase a new couch in the amount of $400. This means you decide to consume $400 of your extra income. The remaining $200 is placed in a savings account. When we plug those numbers into an equation, we get the following:
MPC = change in consumption / change in income
MPC = $400 / $600 = 0.66
Thus, 66% of the extra income was used for consumption.
Another important piece of the marginal propensity to consume is the multiplier effect. The multiplier effect is the term used when the final income increases due to additional spending. In basic terms, we can think of our economy's flow as a circle. When we spend money on goods and services, we inject it into the flow of the economy. This money then goes to the producer of those goods and services so that they can achieve an income and so that they can produce the goods and services we demand and want to purchase. When they produce the goods, they add them to the flow, and when we purchase them, we also add money back to the flow.
So, when we receive extra income on our check, the portion we spend is referred to as the marginal propensity to consume. The amount of the marginal propensity to consume, therefore, contributes to the multiplier effect because extra income leads to extra demands and/or spending and creates more income. This increase in income because of the new injection, or spending, is the multiplier effect.
Additional Formula and Calculations
Okay, let's now learn how to calculate the multiplier effect. Here's the formula we use:
1 / (1-MPC)
If we take our previous example, we know that the MPC is 66%.
1 / 1 - 0.66
1 - 0.66 = 0.34, which means you have decided to spend 66% of every $1 of extra income and have decided to save 34%.
Thus, the multiplier effect = 1/0.34
Multiplier effect = 2.9
Therefore, the multiplier effect is 2.9, which means that for every $1 of new income, it generates $2.90 of extra income in the economy at large.
Marginal propensity to consume is the extra income we receive that we choose to spend on goods and services. When we consume goods and services, we are adding money to the flow of the economy. This money is paid to producers that make the goods and provide the services. They then use that money as income and as a means to produce the goods and services in order to offer them for consumers to purchase. The marginal propensity to consume is the extra money we spend, ultimately creating an increase in demand and spending. The consequence of the extra spending and producing is an overall increase in income, which is called the multiplier effect.
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Marginal Propensity to Consume & Multiplier Effect
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