The Multiplier Effect and Fair Trade

February 12, 2007

Fools are not generous: the world of the gods is not for the stingy. Wise men are generous: they find happiness in the next life.
Dhammapada, pp. 98

A phenomenon exists in Economic Theory that has significant effects in everybody’s life, while only a few are aware of: The Multiplier Effect.

Let’s say that, in general, people in a country save 20% of their income and spend the rest. This 20% is called Marginal Propensity to Save (MPS). The opposite factor, the 80% that people spend is called Marginal Propensity to Consume (MPC). Since they are percentages, they always sum one: MPS+MPC=1.

Now, let’s say that a corn producer community with a MPS of 20% sells corn at $100 the metric ton. The corn is sold in the international markets, and when the producer receives $100, he’ll spend $80 in, let’s say new machinery. The guy who sold the machinery now has $80, so he saves 20% and spends $64 in furniture. The furniture seller now has $64, saves 20% and spend $51.20 in groceries. Successive rounds of spending will be $40.96, $32.76, $26.21 and so on. The initial spending of $100 triggers more spending in a ratio of 5:1. This is called the multiplier, and it’s calculated simply as 1/MPS. In this case, 1/.2=5, so the initial $100 injects the local economy a total of $500:

Corn Multiplier

Because the money came from international markets, the full $500 is reflected as an actual growth in the local economy.

Now let’s say that the Fair Trade price of corn is $120 instead of $100. Apparently the difference for the corn producer is only $20, but for the community is way more:

Corn Multiplier for Fair Trade

The local effect is $100, no $20, due to the multiplier

The 20% saving rate in a rural community is rather high. Rural communities in third world have very low savings rates, because they live in a day by day basis; thus, the multiplier effect is even higher, for a community with only 5% saving rate, the multiplier is 1/.05 = 20 times, so the extra $20 per metric ton translates in a $400 injection to the community.


A key point that derives from the marginal propensity to consume is the paradox of thrift. If people start to save more money, the bank system will have more money to lend to the industry, thus investment will go up and there will be more good and services, and because people is saving more, their future is more secure. What really happen is that now people are spending less, so the demand curve for all goods and services shift to the right. As consumption decrease, so the economy; people start getting fired, companies have to decrease production, and the general income shrink. As income falls, so the savings. People were trying to save more, but they really ended up saving less.

This is why economies like USA’s promote overconsumption, so the economy never shrink. The people live over their limit because the way the economic sectors are integrated, spending more makes the economy grow.