MARGINAL EFFICIENCY OF CAPITAL
Businessmen invest when the return on investment is attractive. Producing in a capitalist economy,
profit is the primary objective of business firms and manufacturing companies. So in order to
maximize their profit, they seek to invest in those ventures that yield higher profit. Before investing,
businessmen compare the yield from the investment and the cost incurred in making the investment.
is only when the return is greater than cost, investment is made.
profit is the primary objective of business firms and manufacturing companies. So in order to
maximize their profit, they seek to invest in those ventures that yield higher profit. Before investing,
businessmen compare the yield from the investment and the cost incurred in making the investment.
is only when the return is greater than cost, investment is made.
KEYNESIAN FRAMEWORK
Keynes introduced the concept of marginal efficiency of capital(henceforth, MEC) in order to analyze
the profitability of the prospect ventures. According to him, investment decisions are made by
comparing the marginal efficiency of capital to the interest rate. The MEC rule is to accept an
investment project if the marginal efficiency of capital is greater than the interest rate. Put differently,
the MEC rule is to accept an investment project if the rate of return is greater than the cost of capital.
the profitability of the prospect ventures. According to him, investment decisions are made by
comparing the marginal efficiency of capital to the interest rate. The MEC rule is to accept an
investment project if the marginal efficiency of capital is greater than the interest rate. Put differently,
the MEC rule is to accept an investment project if the rate of return is greater than the cost of capital.
Of the two determinants of inducement to investment, MEC or expected rate of profit is of
comparatively greater importance than the rate of interest. This is because the interest rate doesn’t
change much in the short run, it is more or less sticky. But changes in the expectations of the profits
make the MEC very unstable and volatile. As a result, investment demand is greatly affected which
causes the aggregate demand to fluctuate. These changes bring about economic fluctuations which are
generally known as trade cycles.
comparatively greater importance than the rate of interest. This is because the interest rate doesn’t
change much in the short run, it is more or less sticky. But changes in the expectations of the profits
make the MEC very unstable and volatile. As a result, investment demand is greatly affected which
causes the aggregate demand to fluctuate. These changes bring about economic fluctuations which are
generally known as trade cycles.
Expectations play an important role in Keynes’s theory and the marginal efficiency of capital is
Keynes’s outlet for expectations. According to Keynes, a collapse of the MEC is the cause of the
economic crisis. It is important to understand the dependence of the marginal efficiency of a given
stock of capital on changes in expectation, because it is chiefly this dependence which renders the
marginal efficiency of capital which explains the violent fluctuations in the business cycle. The MEC
is completely determined by the investor’s expectations about the size and timing of future cash flows,
so the marginal efficiency of capital collapses when there is a collapse in cash flow expectations.
Keynes’s outlet for expectations. According to Keynes, a collapse of the MEC is the cause of the
economic crisis. It is important to understand the dependence of the marginal efficiency of a given
stock of capital on changes in expectation, because it is chiefly this dependence which renders the
marginal efficiency of capital which explains the violent fluctuations in the business cycle. The MEC
is completely determined by the investor’s expectations about the size and timing of future cash flows,
so the marginal efficiency of capital collapses when there is a collapse in cash flow expectations.
MEANING
In ordinary parlance, MEC means the expected rate of profit. Marginal efficiency of a given capital
asset is the highest expected rate of return to the community from an additional unit of a capital asset
which yields the maximum profit which could be produced.
asset is the highest expected rate of return to the community from an additional unit of a capital asset
which yields the maximum profit which could be produced.
Definition: Keynes defined MEC as ‘The rate of discount which makes the present value of the
prospective yield from the capital asset equal to its supply price’.
prospective yield from the capital asset equal to its supply price’.
Thus, Keynes’ marginal theory of capital is bases on two factors:
(i) How much yield an entrepreneur expects to obtain from investment in a particular capital asset,i.e.,
he estimates the prospective yield from the capital asset over his whole life period.
he estimates the prospective yield from the capital asset over his whole life period.
(ii) Price which an entrepreneur has to pay for a particular capital asset, known as supply price.
By deducting the supply price from the prospective yield the entrepreneur can estimate the expected
rate of profit or MEC.
rate of profit or MEC.
Let’s talk more about these two.
1. Prospective yield from capital assets
The term prospective yield is the aggregate net return the investor expects to receive on the sale of
capital assets after the deduction of running costs incurred for the purchase of capital assets considering
its total expected life.
capital assets after the deduction of running costs incurred for the purchase of capital assets considering
its total expected life.
Usually, when the total expected life of the capital asset is divided into a series of periods, generally
years, the annual return is determined. This is represented as Q1, Q2, Q3… Qn and are termed as
annuities.
years, the annual return is determined. This is represented as Q1, Q2, Q3… Qn and are termed as
annuities.
The term “prospective yield” refers to the amount of annual income an investor expects to obtain
from selling the output of his investment or capital assets after deducting the running expenses for
obtaining that output during its life-time. In other words, the prospective yield of a capital asset is the
aggregate net return expected from it during its life-time.
from selling the output of his investment or capital assets after deducting the running expenses for
obtaining that output during its life-time. In other words, the prospective yield of a capital asset is the
aggregate net return expected from it during its life-time.
2. Supply price of this asset
The prospective yield of an asset is, however, not the only thing which an investor will have to
consider while acquiring a new capital asset, that is, machinery, plant or factory. He will also have to
consider the supply price of the asset, that is, the price he has to pay to acquire it, or the cost of
producing the asset.
consider while acquiring a new capital asset, that is, machinery, plant or factory. He will also have to
consider the supply price of the asset, that is, the price he has to pay to acquire it, or the cost of
producing the asset.
It should be noted that the supply price of a particular type of asset is the cost of producing a totally
new asset of that kind, and not the price of the existing asset of that kind. Thus, the supply price of an
asset is alternatively called “replacement cost”.
new asset of that kind, and not the price of the existing asset of that kind. Thus, the supply price of an
asset is alternatively called “replacement cost”.
MATHEMATICAL EXPLANATION
According to Keynes, MEC is the rate of discount which renders the prospective yields from a capital
asset over its whole lifetime equal to the supply price of that asset. Therefore, we obtain the MEC in
the following way:
asset over its whole lifetime equal to the supply price of that asset. Therefore, we obtain the MEC in
the following way:
Supply price = Discounted prospective yields
C = Ri/(1 + r) +Rii/(1 + r)2 + ..... + Rn/(1 + r)n
In the above formula, C stands for supply price and Ri, Rii, …, Rn represent the annual prospective
yields from the capital asset, r is that rate of discount which renders the annual prospective yield equal
to the supply price of the capital asset. Thus, r presents the expected rate of profit or MEC. R/ (1+r)
represents the current value of annuity discounted at rate r.
yields from the capital asset, r is that rate of discount which renders the annual prospective yield equal
to the supply price of the capital asset. Thus, r presents the expected rate of profit or MEC. R/ (1+r)
represents the current value of annuity discounted at rate r.
The MEC is the rate at which the prospective yield from an asset must be discounted to bring it into
equality with the supply price or replacement cost of the capital asset. It is only when the net
prospective yield is greater than the supply price that the investor will be encouraged to take up
investment, because only then can he reasonably hope to earn a surplus over cost. Thus, when the
supply price is greater than the net prospective yield, investment will not be a paying proposition.
equality with the supply price or replacement cost of the capital asset. It is only when the net
prospective yield is greater than the supply price that the investor will be encouraged to take up
investment, because only then can he reasonably hope to earn a surplus over cost. Thus, when the
supply price is greater than the net prospective yield, investment will not be a paying proposition.
DIAGRAMMATIC EXPLANATION
In any given period of time MEC from every type of capital asset will decline as more investment is
undertaken in it. In other words, marginal efficiency of a particular type of capital asset will be sloping
downward as the stock of capital increases. The main reason for the decline in MEC with the increase
in investment in it is that the prospective yields from capital asset fall as more units are installed and
used for production of a good. Prospective yields decline because when more quantity of a good is
produced with a greater amount of a capital, the prices of goods decline. The second reason for the
decline is that the supply price of the capital asset may rise because an increasing demand will bring
about an increase in its cost of production.
undertaken in it. In other words, marginal efficiency of a particular type of capital asset will be sloping
downward as the stock of capital increases. The main reason for the decline in MEC with the increase
in investment in it is that the prospective yields from capital asset fall as more units are installed and
used for production of a good. Prospective yields decline because when more quantity of a good is
produced with a greater amount of a capital, the prices of goods decline. The second reason for the
decline is that the supply price of the capital asset may rise because an increasing demand will bring
about an increase in its cost of production.
In the figure along the x-axis investment is measured and along the the y-axis m e c is shown it will
be seen from the figure that when investment in capital is equal to OI, MEC is i. when investment
increases to OI’, MEC false to i’. when the investment increases to OI’’, MEC falls to i’’.
be seen from the figure that when investment in capital is equal to OI, MEC is i. when investment
increases to OI’, MEC false to i’. when the investment increases to OI’’, MEC falls to i’’.
The equilibrium level of investment will be established at the point where marginal efficiency of
capital becomes equal to the current rate of interest. Thus, the curve of MEC, shows the demand for
investment or inducement to investment at various rates of interest. Hence, the MEC represents the
investment demand curve. This investment demand curve shows how much investment will be
undertaken by entrepreneurs at various rates of interest.
capital becomes equal to the current rate of interest. Thus, the curve of MEC, shows the demand for
investment or inducement to investment at various rates of interest. Hence, the MEC represents the
investment demand curve. This investment demand curve shows how much investment will be
undertaken by entrepreneurs at various rates of interest.
FACTORS CAUSING A SHIFT IN THE MEC
There are a number of factors that are responsible that cause a shift in the investment demand
function. Some of the most prominent factors include:
function. Some of the most prominent factors include:
- Cost of capital .
- Change in technology
- Demand for goods and services
- Tax rates
- Facilities for finance
- Future trade expectations
BUSINESS EXPECTATIONS AND INVESTMENT DEMAND
It is the profit Expectations of the entrepreneur which determine the level of investment. When
expectations of the entrepreneur regarding profit making become dim, the MEC declines and as a
result the demand for investment falls. The occurrence of depression is mainly due to the pessimistic
expectations of the entrepreneurial class regarding profit making. On the contrary, when the
expectations of entrepreneurs regarding profit opportunities increase, their inducement to invest
rises. As a result of the increase in investment, aggregate demand in the economy increases and the
levels of income and employment increase.
expectations of the entrepreneur regarding profit making become dim, the MEC declines and as a
result the demand for investment falls. The occurrence of depression is mainly due to the pessimistic
expectations of the entrepreneurial class regarding profit making. On the contrary, when the
expectations of entrepreneurs regarding profit opportunities increase, their inducement to invest
rises. As a result of the increase in investment, aggregate demand in the economy increases and the
levels of income and employment increase.
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