Lesson 6:

Marginal Efficiency of Capital and Investment

Objective of the Lesson:
After studying this lesson you are able to understand the following:

The Concept of Marginal efficiency of capital

The Concept of Marginal efficiency of Investment.
The Relationship between MEC and MEI

6.1 Introduction
6.2 Marginal Efficiency of Capital
6.3 Marginal efficiency of capital and Investment
6.4 Marginal efficiency of Investment Schedule (Long run and Short run)
6.5 Summary
6.6 Glossary
6.7 Model Questions
6.8 Further Readings

6.1 Introduction:

In fact, Investment is a flow variable and Capital is Stock variable. Capital means initial amount
spent by an entrepreneur at the time of establishment of an industry and the Investment means
that the recurring expenditure while running an Industry. In attaining equilibrium level of output,
income and expenditure in an economy, investment plays an important role besides
Consumption. Hence, the importance of Investment in any economy cannot be over emphasized.
It is in this context, one has to identify the determinants of Investment. As a part of it,
economists have tried to explain the determinants of Investment in their theories of Investment.
These Theories are known as:
  Neoclassical Marginal Productivity theory of Capital Or MPK Theory of Investment
 Keynesian theory of Investment or Marginal Efficiency of Capital or MEC theory
 Profit Theory of Investment
 Acceleration Theory of Investment
 Financial Theory of Investment

6.2 Marginal Efficiency of Capital Theory:

Marginal Efficiency of Capital (MEC) theory is propounded by JM Keynes. According to him,

important determinants of Investment are a) Marginal Efficiency of Capital b) Rate of Interest.
Therefore, according to him, Investment is the function of MEC and Rate of Interest. It implies
that the changes in MEC and Rate of Interest certainly give a scope to take an Investment
Decision.

As you are aware, theory of investment propounded by Keynes is to show a solution to come out
from depression which was faced by all economies in the world. Thus in his framework, he
fallowed demand management method. It means that by raising Effective Demand (combination
of Aggregate Demand and Aggregate Supply), economies can easily come out of depression.
Further he stated that effective demand will be determined by two factors, Demand for
Consumption and Demand for Investment. According to him, Demand for consumption is mostly
influenced by human Psychology therefore, Induced Investment (but not autonomous
investment) will play crucial role. Keynes suggests that Investment depends not only on the
present returns but also on all the expected annual returns over the life span of the plant. It means
that, Decision of Investment is not only depend on MEC in turn it depends upon Sales value of
Assets and Prospective Yield.

6.3 Concept of Marginal Efficiency of Capital and its Measurement:

Now, let us try to understand the concept of MEC more clearly. Before investing, any
entrepreneur would like to find out if it is really worth to do so. For this, the relationship
between three elements viz., the expected income flows over the life span of the capital good
under consideration, the market rate of interest and the purchase price of the capital or asset
under consideration becomes crucial. The inducement to invest will be strong if the value of an
additional capital good exceeds its Cost or the supply price of or replacement cost. The value of
an additional unit of Capital good depends on two elements. One, the series of prospective
annual returns which are expected from the capital good over its lifespan and secondly, the rate
of interest at which these expected annual returns are discounted. In other words, if we represent
the annual returns by R1, R2, R3, ………… Rn, and i stands for the market rate of interest and V stands
for the Value of the capital under consideration, then

R1 R2 R3 Rn
V= ------------- + ------------- + -------------- + …………… + ---------------

(1 + i ) (1 + i )2 (1 + i )3 (1 + i )n

As long as the Value of capital goods, which is determined by the annual returns (R’s) and the
market rate of interest (i), exceeds the supply price or Replacement Cost of the Capital good
(CR), it will be profitable to continue to invest.

The same thing can be explained in terms of Marginal Efficiency of Capital ( r) also. Actually, r
stands for the market rate of discount that makes the present value of the series of annual returns,
just equal to the supply price of capital. Thus, r can be calculated in the following manner:

R1 R2 R3 Rn
CR = ------------- + ------------- + -------------- + …………… + ---------------

2 3
(1 + i ) (1 + i ) (1 + i ) (1 + i )n

R1 + R2 + R3 + …… + Rn being the series of prospective annual returns, or prospective yield of

the investment, and CR the Replacement Cost, let r stand for the rate of discount which would
make the present value of the series of annual returns just equal to the supply price (replacement
cost) of the capital goods. Thus, r is the rate of discount which will equate the present Value of
the prospective annual returns to the Cost of the capital goods; in other words, r is the Marginal
Efficiency of Capital (Keynes) or the rate of return over cost (Fisher) which one can expect to
earn on a capital asset costing CR and yielding a series of returns represented by R 1 + R2 + R3 +
…… + Rn.

6.4 Relationship between MEC and Investment:

Within the pattern of a given set of expectations, the amount of investment, which is
economically feasible within a given period, will depend partly upon the elasticity of the
Marginal Efficiency of Capital schedule and partly upon the elasticity of the current supply price
of capital goods. On the one side, the diminishing marginal productivity of each successive
increment of capital goods will reduce the prospective yield (series of annual returns); and, on
the other side, the cost of a unit of capital goods will increase since a larger volume of
investment will put pressure on the facilities for producing that type of capital. As CR rises while
the “prospective yield” (i.e., the series of R’s) falls, the rate of discount (that is, r) required to
equate the present value of the series of returns to replacement cost will decline. The larger the
volume of investment I within a given period of time, the lower will be the prospective annual
returns, i.e., the R’s and the higher will be the replacement cost. Accordingly, the larger the
volume of investment, the lower will be the rate of return over cost, namely, r.

The schedule relating I and r is the investment-demand schedule. Investment will be pushed to
the point on the investment-demand schedule where the marginal efficiency of capital in general
is equal to the market rate of interest. Thus, the intersection of the r curve (the marginal
efficiency schedule) and the i curve (the interest-rate schedule) will determine the volume of
investment within a given period of time.

The same thing can also be expressed as follows: Within a given pattern of expectations,
determined basically by technological developments and population growth and in the short run
by all sorts of expectations, the volume of investment in any given period of time will be
determined by the intersection of the V curve and the CR curve.

The V curve is the demand price of investment, and the CR curve is the supply price of investment,
where V means the value of a unit of capital goods and CR the replacement cost of a unit of
capital goods. As investment increase within a given period of time, V falls while CR rises.
Investment will be pushed to the point on the V curve where V =CR.
Thus, the total investment within a given period (determined by the intersection of the V curve
and the CR curve) would rise. Alternatively, the intersection of the marginal efficiency (r)
schedule with the i curve, in view of the lower rate of interest. The resulting greater stock of
capital goods means a lower marginal efficiency of capital.

Thus if the future rate of interest is likely to be lower than the present rate, a larger volume of
future equipment, promising a lower rate of return over cost will offer stiff competition for
today’s equipment in future years. This expectation of a lower interest rate in the future may
have some depressing effect upon current investment.

Keynes stressed the role of expectations with respect to the investment-demand schedule, and he
concludes the chapter by emphasizing this point once again. It is mainly through the investment-
demand schedule that the expectations of the future influences the present. Static economics, he
says, has made the mistake of taking account primarily of the current yield of capital equipment.
But this would be correct only in the static state where there is no changing future to influence
the present.
MEC & i (in %)

i - Curve

MEC - Curve

Investment
All that was explained above is depicted above in the diagram in terms of the Investment
Demand Schedule or curve. The curve relates different amounts of investment at different
MECs. Investment is pushed to a point on the Investment Demand curve where r = i. One can
easily understand that as investment increases, i, the interest rate is bound to go up because of the
strain on resources, while, MEC is bound to fall because of the law of diminishing marginal
product.. Thus, in a given period of time, the intersection of r and i curves will determine the
volume of profitable investment.

Shifts in the MEC curve:

There is a need to distinguish between moving up and down on the same MEC curve and Shifts
in the MEC curve itself. A fall or a rise in the rate of interest causes will cause a movement
along the MEC curve and will not lead to a shift. But there is a possibility of the MEC curve
shifting to the right upwards or to the left downwards. Shifts in the MEC curve take place when
business men revise their expectations. An optimistic outlook on the part of the businessmen or
a change in Technology for the better may bring about an upward shift in the MEC curve.

6.5 The MEI Schedule (Long run and Short run):

All the discussion above dealt with only one factor that influences the rate of net investment
spending—the growth in the stock of capital, represented graphically by a movement down the
MEC schedule. This factor becomes important only in the long run; then the growth in the stock
of capital is large enough, relative to the pre-existing stock of capital, to cause an appreciable
movement down the MEI schedule in the long run and in the short run.

The distinction between the long run and short run has to be made because all the above
discussion is about the long run, and involves situations where the net investment expenditures
of each period are sizable relative to the capital stock at the beginning of each period. This in
turn mean that the resulting change in the stock of capital in each period would push down the
MEI schedule perceptibly in the next period until that schedule eventually reached the level at
which net investment expenditures became zero. But in the short run, the addition to the stock of
capital resulting from net investment expenditures being insignificant relative to the large
existing capital stock. Therefore, the downward shift in the MEI schedule will be
correspondingly insignificant.

In the long run, net investment expenditures do move the economy along the MEC schedule.
With the MEC schedule sloping downward, the result must be a downward shift of the MEI
schedule and, assuming an unchanging supply curve for capital goods, a decrease in the rate of
net investment expenditures. However, here, we need look only one way—a difference between
the actual and the profit-maximizing capital stock affects net investment expenditures, but these
expenditures in the short run do not appreciably affect the economy’s position along the MEC
schedule.

6.6 Summary

As we have seen, Keynes’s marginal efficiency of capital is rigorously defined as “that rate of
discount which would make the present value of the series of annuities given by the returns
expected from the capital asset during its life, just equal to its supply price”. In other words, that
rate of discount, which will make the present value of the series of prospective annual returns
equal to the replacement cost of the capital goods in question.

Our concern in this chapter essentially has been the MEC curve, its relationship with Investment,
the relationships between the stock of capital and the rate of investment. If at any point in time
the actual stock equals the profit-maximizing stock, an excess of the later over the former will
appear subsequently only if the market rate of interest falls or if the MEC schedule shifts
upward. Either change will produce a positive rate of net investment spending. For short-run
analysis, the indicated rate of net investment spending may continue unchanged. However, in
the long run, the rise in the stock of capital resulting from net investment spending will depress
the MEI schedule and with it the rate of net investment spending.
 Rate of Interest (in %)

MEI - Curve

Investment

Keynes believes that Marginal Efficiency of Capital is an important concept as it is one of the
important determinants of Investment. He believed that investment depended not only on the
present returns of capital, but also on all the expected annual returns over the life span of
capital. This is why; this concept involves an element of time. In order to estimate the value
of additional capital, two elements are to be considered. One, the prospective annual yields
which are expected from capital over its life span, and secondly, the rate of interest at which
these expected annual returns are discounted. Investment will be pushed to the point on the
investment demand schedule where the MEC in general is equal to the market rate of interest.
This will call for the determination of the MEC schedule and the interest rate schedule, and
to find out the point of intersection so as to determine the volume of investment in a given
period. In the short-run, firms operate on the MEC curve by moving up or down on the same
curve, but in the long-run the MEC curve itself shifts to the right upwards or to the left
downwards.

6.7 Glossary

Marginal Efficiency of Capital

Marginal Efficiency of Investment

Depression
 Prospective Yield

Discount Rate

Expectation

6.8 Model Questions:

1. Define the Concept of Marginal Efficiency of Capital

2. Explain the relationship between MEC and rate of Interest.
3. Establish the relationship between MEC and Sales Value of Assets
4. Examine the implications of upward or downward movements on MEC curve and Shifts
in the MEC curve.
5. Enlist the factors that determine MEC. What is the role of Expectations in Investment
decisions
6. Analyse how the level of Investment is determined by MEC

6.9 Further Readings:

1. Edward Shapiro: Macro Economic Analysis, Golgotia Publications (P) Ltd.

2. G. Ackley : Macro Economic Theory, Macmillan Publications.

3. Sampath Mukherjee: Analytical Macro Economics from Keynes to Mankiw,

New Central Book Agency, Kolkata.