This is a solution of Unit 1 Business Environment Lecture Note Seven that describes about Developing business
Unit 1 Business Environment Lecture Note Seven
The terms “marginal propensity to save” and “marginal propensity to consume”are economic terms used to discuss how an entity deals with surplus income. These terms are especially important components of Keynesian economics. Small business owners who understand them and their implications can use the terms to analyse how their businesses handle extra income.
Marginal Propensity to Consume
The marginal propensity to consume, sometimes referred to simply as MPC, is used to determine what part of an entity’s extra money is consumed, or spent. MPC indicates how consuming changes as income changes. It can be expressed as the ratio of an entity’s change in spending over its change in income. For example, imagine a business environment began earning £200 extra per month. The business than begins to spend an extra £100 per month. The MPC is 50 percent; of each extra dollar the company earns, about 50 cents is spent.
Marginal Propensity to Save
The marginal propensity to save, or MPS, is used to determine what part of an entity’s extra income is saved. MPS indicates how saving changes as income changes. MPS is the ratio of an entity’s change in savings to its change in income. For example, if a business earns £200 of extra income a month and begins to save an additional £100 per month, the MPS is 50 percent.
MPC and MPS have an inverse relationship. Because they add up to 100 percent, as MPS increases, MPC decreases and vice versa. For example, if a company earns an extra £200 per month in income and consumes, or spends, $100 extra per month, £100 per month is saved. The MPS and MPC are both 50 percent. If the business starts to spend £150 per month, only £50 is saved. The MPC increases to 75 percent, while the MPS decreases to 25 percent. See more about : BTEC HND in Business Assignment
MPS and MPC reflect the Keynesian law that people tend to spend most of their extra income. Knowing this law and studying how their spending and savings change with time can help small businesses be more deliberate when they earn extra income. They can use MPS and MPC data to set goals that will help them increase their MPS, allowing them to save more money.
Factors that determine the marginal propensity to consume/save are:-
- Income levelsat low income levels, an increase in income is likely to see a high marginal propensity to consume; this is because people on low incomes have many goods / services they need to buy. However, at higher income levels, people tend to have a greater preference to save because they have most goods they need already.
- Temporary / permanent.If people receive a bonus, then they may be more inclined to save this temporary rise in income. However, if they gain a permanent increase in income, they may have greater confidence to spend it.
- Interest rates. A higher interest rate may encourage spending rather than consumption, however the effect is fairly limited because higher interest rates also increase income from saving, reducing the need to save.
- Consumer confidence. If confidence is high, this will encourage people to spend. If people are pessimistic (e.g. expect unemployment / recession) then they will tend to delay spending decisions and there will be a low MPC.
- Marginal propensity to consume and the multiplier
The multiplier effect states that an injection into the circular flow (e.g. government spending or investment) can lead to a bigger final increase in real GDP. This is because the initial injection leads to knock on effects and further rounds of spending.
The essential element of Keynesian economics is the idea the macro economy can be in disequilibrium (recession) for a considerable time. Keynesian economics advocates government intervention to help overcome the lack of aggregate demand to reduce unemployment and increase growth.
Theory behind Keynesian Economics
- If saving exceeds investment we get a recession
Classical theory suggested any fall in investment would lead to lower interest rates; this fall in interest rates would reduce saving, increase investment and cause the economy to return to a new equilibrium of full employment. However, Keynes’ analysis suggests this is unlikely to occur, due to a number of factors, such as a liquidity trap and the general glut of savings.
Why Keynes felt Recessions could last a long time
- Lower interest rates may not increase consumption very much because the income effectof lower interest rates means people have more income.
- Liquidity trap. When interest rates fail to boost demand. Interest rates can’t fall below a lower bound rate of zero, and lower interest rates are ineffective in boosting demand anyway.
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