DETERMINATION OF MARGINAL EFFECIENCY OF

CAPITAL

Meaning of Marginal Efficiency of Capital

Irving Fisher, 1930 was the first economist who made use of the concept of
marginal efficiency of capital. He gave it the name of Rate of Return over Cost. In
simple words, marginal efficiency of capital means: expected rate of possibility of
new investment. Term efficiency has been used to mean ‘Rate of Income.’ In other
words, marginal efficiency of capital means income received after deducting the
cost from the return of an additional unit of capital. Its calculation depends on two
factors: i) The amount of profit which is expected by investing one more unit of
capital asset and ii) cost of capital asset. M.E.C. can be calculated by deducting
from total income of capital asset its cost. Suppose the price of a machine is Rs.
40,000. The duration of life of this machine is 20 years. During this period it is
expected to yield an income of Rs. 70,000. Thus the total profit of machine is
Rs.70,000- Rs. 40,000 = Rs. 30,000 only. Hence profit per year will be
Rs.30,000/20 = Rs. 1500. This profit is earned on an investment of Rs.40,000,
M.E.C. is therefore, Rs. 1500/40,000 x100 = 3.75%

Definitions

Stonier: The Marginal Efficiency of any asset shows what an entrepreneur

expects to be able to earn from acquiring one more asset of that kind compared
with what he has to pay to buy it

Kurihara: M.E.C. is the ratio between the prospective yield of additional capital
goods and their supply price.
Determinants of Marginal efficiency Capital

Marginal efficiency of Capital is governed by the expected yield of a capital asset

and its supply price. In technical term the same are called:

I.Prospective yield: It is the aggregate net return expected from it during its
whole life. In order to determine prospective yield, annual return of the capital is
worked out. Aggregate of annual return expected from a capital asset over its life-
time, is called total prospective yield. The remainder, after deducting cost of
production from total revenue earned by the sale of output produced with the help
of capital asset, is called prospective yield. With rise in prices, prospective yield
increases and with the fall in prices, it decreases. Prices are likely to change in the
be expressed in terms of the following equations:

Py = Q1 + Q2 + Q3 + Q4 +………+ Qn

(Here Py= Prospective Yield; Q1, Q2, Q3, Q4 and Qn = net revenue received in
the first, second, third, fourth and nth year)

II. Supply Price : The other factor influencing M.E.C. of a capital asset is its
supply price. The supply price of a capital asset is the cost of producing a new
asset of that kind, not the supply price of an existing asset. Hence, the supply price
of a capital asset is also called Replacement Cost. It remains fixed in the short
period.

Formula for Determining Marginal Efficiency of Capital

Marginal efficiency of capital is determined by i) prospective yield and ii) supply

price. It can be expressed in terms of an equation. A capital asset actually remains
operative for more than one year. Hence, its total prospective yield is the aggregate
of annual prospective yields throughout its life-period. Prospective yield can be
found out like compound interest from the principal amount, that is, supply price of
capital asset and marginal efficiency of capital. Hence, in the first year,

Py1 = SP(1+m)

Or SP = Py1/(1+m)

(Here, Py = Prospective Yield; SP = Supply Price ; m = MEC)

In the second year Py becomes the principal amount. Hence,

Py2 = Py2(1+m)

Because Py1 = SP(1+m), hence

Py2 = SP(1+m)(1+m) = (1+m)2

In the 3rd year Py2 becomes the principal amount. Hence,

Py3 = Py2(1+m)

Because Py2 = SP(1+m)2, hence

Py3 = SP(1+m)2(1+m) = SP(1+m)3 Or

SP = Py3/(1+m)3

Supposing, Life time of a capital asset is five years. In these five years, the
aggregate of net return expected by the use of capital asset will be called
Prospective Yield. In other words, the aggregate of expected net return of all the
years over total life-time of a capital asset is called prospective yield. In ‘n’ years,
we can know the supply price of a capital asset.
DETERMINATION OF M.E.C. IN THE FORM OF RATE
OF DISCOUNT

Rate of discount is that rate which equates future value of a capital asset
with its present value. Lord Keynes has explained marginal efficiency of
capital in terms of that discount rate which makes the prospective yields
of a capital asset equal to its supply price. In the words of Keynes, “I
define the MEC as being equal to that rate of discount which would make
present value of the series of annuities given by the return expected from
the capital asset during its life just equal to its supply price.” In simple
words, in order to equate prospective yield of a capital asset with its
supply price, marginal efficiency is deducted from it. Thus,
Supply Price = Discounted Prospective Yield
It is further clarified with the help of the following equation:
SP = Py1/(1+m) + Py2/(1+m) + Py3/(1+m) +………+
Pyn/(1+m)
(Here SP = Supply Price; Py1, Py2, Pyn = 1st year, 2nd year and nth year
prospective yield; m=Marginal Efficiency of Capital)

Marginal Efficiency of Capital can be known with the help of above

equation. It has already been made clear that in dynamic society, annual
prospective of a capital asset goes on changing every year. As a matter of
fact, there is some rate of discount or marginal efficiency of capital that
equates both sides of the equation. It is further illustrated by a example.
Supposing, the supply price of a capital asset is Rs.1800. Total life-span
of this capital asset is 2 years. Prospective yield of this capital asset in the
first year, is Rs.1050 and in the second year Rs.882. Thus, five percent is
that rate of discount which will equate the aggregate prospective yield of
the capital asset pertaining to both year with its supply price.
Rs. 1800 = Rs. 1050/(1+0.05) + Rs. 882/(1+0.05)
In the above equation, 5% rate of discount equates total prospective yield
of capital asset with its supply price. It will be called marginal efficiency
of capital. According to Prof. Keiser, “The marginal efficiency of capital
is the rate at which the prospective yield from an asset must be
discounted to bring it into quality with the supply price.”

Further Marginal efficiency of capital, Be determined by supply price

(p) and
expected rate of returns (annual returns) (Q).
Marginal efficiency of capital, e= f (Q,P)
There is a negative relationship between MEC and the volume of
investment. This negative relationship is due to three reasons:
1. Keeping all other factors constant, when the volume of investment
increases, law of diminishing returns operates and the productivity of
increasing factor decrease.
2. When, the production increases, the product prices may decrease
causing a decline in the rates of returns and marginal efficiency of
capital.
3. When, the demand for other factors increases the factor prices may
increase causing increase in cost of production and decrease in marginal
efficiency of capital.
With increasing levels of investment, MEC can be kept constant. This is
possible only by shifting the MEC curve. Shift in the MEC curve means a
change in the production function and change in the level of technology.

FACTORS DETERMINING M.E.C.

Marginal efficiency of capital depends on two sets of factors:
a. Short run factors, and
b. Long run factors
a. Short run factors
Short run factors are important in determining marginal efficiency of
capital as well as investment. Following are the long run factors affecting
marginal efficiency of capital:
1. Marginal propensity of consumption
Increasing level of marginal propensity of consumption increases
marginal efficiency of capital. The intensity of consumption encourages
marginal efficiency of capital.
2. Income
Higher levels of income yield larger marginal efficiency of capital.
Increasing income will also increase conspicuous consumption.

3. Price level
During periods of inflation marginal efficiency of capital will be high.
Price levels with more money supply will increase capacity to pay.
4. Interest rate
Higher interest rates discourage marginal efficiency of capital. Higher
cost of capital increases cost of production thus reducing chances of
increasing marginal efficiency of capital
5. Consumption expenditure
Higher consumption expenditure increases the marginal efficiency of
capital. Increasing consumption expenditure can be due to reasons like
income, price levels, demonstration effect or price illusion.
6. Government Policy
Government policy of taxation, controls on output will reduce the
possibility of increasing marginal efficiency of capital.
7. Business cycles
Business cycles mainly deal with mood in business environment.
There can be business optimism or business pessimism. During 17
periods of business optimism the marginal efficiency of capital will be
high similarly, during periods of business pessimism, marginal efficiency
of capital will be low.
8. Rational expectations
A rational expectation is a post Keynesian concept, concerned with
business environment and business. It is regarding the business adapting
to changing policy, market, consumer expectation and management of
business with rational risk management.
b. Long run factors
Long run factors do not fall under the study of Keynes, because,
Keynesian economics is short run economics. Yet, these are the factors
which are effective in the ling run. Following are the long run factors
affecting marginal efficiency of capital:

1. Population
Though population changes even in the short run. The effect of
population can be seen only in the ling run, by way of changes in the
pattern of demand and labor force.
2. Technology
Technology helps in the ling run in reducing costs and making
production function efficient.
3. Alternative sources of raw material and energy
Alternative and cheaper sources of raw material and energy change
the production function and help in expanding out put and making it
economical.
4. Expanding markets
Expanding markets provide purpose for the industry to produce and
distribute. In the long run, mass consumption increase.