Propensity exists in dozens of different forms in the world of economics – to invest, spend, save, import, export, etc. In layman’s English, propensity is a natural tendency to behave or do things in a certain way. For example, cats have a tendency to hunt birds, while humans are inclined to acquire material possessions.
In every case, it is important to know the difference between average and marginal propensities.
– The average propensity to consume: is total consumption divided by total income. It expresses the percentage of income that is used for consumption, i.e. what proportion of your income you spend.
– The marginal propensity to consume: refers to how much of each extra dollar, pound, euro of income is used for consumption (as opposed to savings).
As you can see in the image above, the two propensities for consumption – marginal and average – are not the same. The employee spends 75% of her annual income, and 25% of any additional income she receives. Her average and marginal propensities are 75% and 25% respectively.
Working out the average is much easier than trying to calculate or predict the marginal propensity.
Businessdictionary.com defines the marginal propensity to consume as:
“Proportion of a small change in the disposable income that would be spent on consumption instead of being saved. It is computed by dividing the change in consumption by the change in disposable income that caused it.”
MyAccountingCourse.com says that the average propensity to consume:
“Expresses the percentage of income consumed at any given level of income. In other words, it’s the amount of income the average consumer spends on goods and services.”
Tom is a good saver. He saves one quarter of his annual income and about seventy-five percent of any additional money he earns or receives. Therefore, his Average and Marginal propensities to save are 25% and 75% respectively.
Propensity to save
In economics, this refers to the percentage of total income or of an increase in income that people save instead of spending on products and services.
– The Average Propensity to Save: also known as the savings ratio, is the ratio of total savings to total income. It is usually expressed as household savings as a fraction or percentage of total household disposable income.
– The Marginal Propensity to Save: is the ratio of a change in savings to a change in income.
The propensities to save and consume, when added together, should always equal one or 100%.
Our inclination to buy imported goods
When individuals and companies buy things, a percentage of those goods and services were created at home, and a percentage were made abroad.
– The Average Propensity to Import: this is the amount of money a consumer spends on imports as a percentage of his or her total income. For example, if you earn $60,000 and spend $15,000 of that income on imported goods, your average propensity to import is 25% (15,000 is 15% of 60,000).
– The Marginal Propensity to Import: this refers to the percentage change in import expenditure that occurs when your disposable income (spare cash) goes up or down.
For example, if you earn an extra $10 dollars of disposable income, and your marginal propensity to import is 0.2, you will spend $2 of those $10 on imported goods and services.
In countries where consumers buy lots of imported goods and services, such as the USA and UK, an effective way of controlling the current account on the balance of payments (decrease imports) is to reduce their disposable income – raise the income tax rate.