Definition
The marginal propensity to consume (MPC) is the share of a rise in income that gets spent on consumption. It looks only at the new money, not the money you already had. The rest goes to savings, so the share spent and the share saved always add up to one.
Where does extra birthday money go?
Say your holiday gift money this year is $10 more than last year. Two friends get the same extra amount, but they do very different things with it.
One friend spends $8 of it on tacos and a stop at the stationery store. Only the last $2 goes into the piggy bank. The other friend does the opposite: most of it goes into the piggy bank, and just a little gets spent.
The share of the extra money that gets spent is the marginal propensity to consume. The first friend spent $8 of the extra $10, so the value is 0.8. It's the number for the part of new income that goes to spending.
Here's the key point: we only look at the extra part. It's not about how you spend the allowance you already had. It measures which way the newly arrived money flows.
Why does this ratio matter?
Let's zoom out from the gift money to the whole neighborhood. The money the first friend spent at the taco stand doesn't just vanish. It becomes the stand owner's income right away.
The owner will spend part of that income at the market. Then that money becomes someone else's income. One person's spending turns into the next person's income, and the money makes a lap around the neighborhood.
The higher the MPC of the people who receive money, the longer that chain runs. By contrast, money that goes straight into a piggy bank never reaches a shop's sales. The same dollar can have a different effect on the neighborhood depending on who gets it.
That's why governments pay attention to this ratio when they hand out relief payments in hard times. Households with tighter budgets tend to have a higher MPC. They have needs piled up, so extra money goes straight to spending.
A little more precisely
To be a bit more precise, this value is not the same as the share of your total income that you spend. Back to the gift money: you don't count everything in your wallet. You look only at the extra $10.
The value usually falls between 0 and 1. Spend all of the extra money and it's 1. Save all of it and it's 0. Most people land somewhere in between. Whatever isn't spent is saved, so the two shares always add up to 1.
There's one catch. A one-time lump sum and a steady raise that shows up every month don't act the same. When people feel the money will keep coming in, they tend to spend more of it.
Also, this value differs from person to person and changes over time. So it's less a fixed number and more a rough gauge of how much people tend to spend.
Common misconceptions
The marginal propensity to consume is the share of your total income that you spend.
It looks only at the newly added part, not the total. It shows how much of an income increase went to spending.
The more income someone has, the higher their MPC.
Higher earners spend bigger amounts overall. But the share of extra money they spend tends to be lower.
Where you meet it
Your hourly wage at a part-time job goes up, and you take home a bit more each month. How much of that extra you spend versus save is your MPC.
When holiday gift money goes up, one person immediately buys something they've wanted, while another puts it in a bank account. Their MPCs are very different.
In one sentence
It's the share of an income increase that goes to spending.