Question

In year \(1,\) Adam earns \(1,000\) and saves \(100 .\) In year \(2,\) Adam gets a \(500\) raise so that he earns a total of \(\$ 1,500 .\) Out of that S1,500, he saves \$200. What is Adam's MPC out of his \$500 raise? LO30.1 a. 0.50 b. 0.75 c. 0.80 d. 1.00

Short answer

Adam's MPC is 0.80, which corresponds to option c.

Step-by-step solution

Understanding Marginal Propensity to Consume (MPC)

MPC, or Marginal Propensity to Consume, is a measure in economics that shows the percent of additional income spent on consumption. It is calculated as the change in consumption divided by the change in income.

Determine the Change in Income

Adam's income increases from year 1 to year 2 by \$500. This increment is his raise. So, the change in income is \( \Delta Y = 500 \).

Determine the Change in Savings

In year 1, Adam saves \\(100. In year 2, he saves \\)200. Therefore, the change in savings is \( \Delta S = 200 - 100 = 100 \).

Calculate the Change in Consumption

The change in consumption is given by the difference between the change in income and the change in savings, because any money not saved is spent on consumption. Thus, \( \Delta C = 500 - 100 = 400 \).

Calculate MPC

MPC is calculated as the change in consumption divided by the change in income. So, \( MPC = \frac{\Delta C}{\Delta Y} = \frac{400}{500} = 0.8 \).

Key concepts

Economic Principles

The heart of economics lies in its principles that help us understand how individuals make decisions in the face of scarcity. One of the fundamental concepts is how individuals allocate their income between different needs and wants. For example, when analyzing a raise in income, it's crucial to determine how much of it will be saved and how much will be used for consumption.

Concepts such as the Marginal Propensity to Consume (MPC) provide insights into these decisions. The MPC measures how much additional income is spent rather than saved. This concept is essential in economics as it affects overall economic activity and growth. A higher MPC means more disposable income is being pumped back into the economy as consumption. Lower MPC implies higher savings.

The interplay between saving and spending is part of broader economic dynamics. It is important for understanding economic policies and designing strategies to stimulate economic growth. By using tools like the MPC, economists can predict consumer behavior in response to changes in income, taxes, and economic conditions.

Income and Savings

Income and savings are two sides of personal finance management. How one manages their income has a significant influence on financial stability and future investments. The basic idea is simple:

• Income: This is the money earned from work or investments.


• Savings: This is the portion of income that is not spent or consumed.

When individuals receive a raise, like Adam did in the exercise, they must decide what portion of this increase will be saved versus spent. In Adam's case, despite his increased income, a portion went directly into additional savings.

Savings are crucial for creating a financial buffer, allowing for large purchases, or securing one's future. They are also a key consideration for economic models that require understanding the link between spending behavior and saving rates. As one saves more, it reduces immediate consumption, which might influence aggregate demand in the economy.

Consumption Function

Consumption function is an economic concept that helps to establish the relationship between total consumption and gross national income. It demonstrates how much people plan to spend versus save at different income levels.

A central element of the consumption function is the Marginal Propensity to Consume (MPC). This represents the fractional increase in consumption when income grows. In economic theory, it is assumed that a rise in income results in both an increase in consumption and savings. However, MPC shows which part of an income increase is spent. For example, Adam's MPC of 0.8 means he spent 80% of his additional income on consumption.

Understanding the consumption function aids in predicting economic activity. Economic policies often consider consumption patterns to influence growth. With higher MPC values, consumer spending is robust, potentially leading to increased production and employment. In contrast, a lower MPC might indicate a more significant propensity to save which could stall economic activity if widespread.

The consumption function, therefore, remains a valuable tool for analyzing economic behavior, both at the individual and national levels.