Concept of Marginal Efficiency of Capital

Marginal efficiency of capital refers to the expected profitability of a capital asset. It may be defined as the highest rate of return over cost expected from the marginal or additional unit of a capital asset. First we must go to the marginal unit of the capital asset and secondly its cost has to be deducted from its return.

Now the MEC in its turn, depends on two factors: the prospective yield of the capital asset and the supply price of the capital asset. The MEC is the ratio of these two factors. The prospective yield of a capital asset is the total net return from the asset over its life time.

The supply price of an asset is the cost of producing a brand new asset of that kind and not the supply price of an existing asset. It is referred to as the replacement cost. If the supply price of a capital asset is Rs. 20,000 and its annual yield is Rs. 2000, then the marginal efficiency of this asset is 2000/20000 x 100 = 10 percent. Thus the marginal efficiency of capital is the percentage of profit expected from a given investment on a capital asset.

Keynes relates the prospective yield of a capital asset to its supply price and defines MEC “as being equal to 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 equal to its supply price”. This may be put in the form of an equation.

Where Sp is the supply price or the cost of capital asset, R₁,R₂… Rn are the prospective yields or the series of expected annual returns from the capital asset in the years 1,2…….. n, and i is the rate of discount. This makes the capital asset exactly equal to the present value of the expected yield from it.

Factors of Marginal Efficiency of Capital (MEC):

The various factors that bring about shifts in MEC are short run or endogenous factors and long rim or exogenous factors.

The short run factors are:

1. Expected demand

If the demand for the product is expected to be high in future, the MEC will be high and the investment will increase. On the other hand if the demand for the product is expected to decline in future the MEC will be low and investment will fall.

2. Costs and prices

If the costs are expected to decline and if the prices are expected to increase, the expectation of the producer will go up. On the other hand if the costs are expected to go up and prices are to decline the MEC will receive a set back and the investment will be less.

3. Propensity to consume

If the propensity to consume is more than the volume of investment will be more and vice versa.

4. Changes in income

An increase in the level of income will stimulate investment while a decrease in the level of income will discourage investment.

5. Current state of expectation

Businessmen while making expectations take into account the current state of affairs regarding costs, prices, returns etc. If they are high the MEC is bound to be high for new projects of investment.

6. Level of confidence

During period of optimism the businessmen over estimate and boost the MEC of capital assets. During period of pessimism they under estimate and reduce the MEC of capital assets.

The long run factors which influence the MEC are as follows:

1. Population growth

A rapidly growing population means a rapid increase in the demand for all types of goods and hence investment rises and conversely, a decline in population will decrease the demand investment.

2. Development of new areas

When a new area is developed heavy investments in all fields such as agriculture, industries, electricity, housing etc., are to be undertaken.

3. Technological factors

New invention or new discovery may necessitate the installation of new machineries in the industrial enterprise and encourage investment.

4. Productive capacity of the Industry

If the existing capacity is fully utilised then any further increase in demand will be met with by making fresh investment on new capital equipment.

5. Level of current investment

If the existing level of investment is already high there will be little scope for further investment and vice versa.

Criticism of the Marginal Efficiency of Capital:

Keynes used the term marginal efficiency of capital in a vague manner. Secondly, Keynes failed to recognize that interest rates are also governed by expectations like the marginal efficiency of capital. He considered marginal efficiency of capital in the field of dynamic economics and rate of interest in the field of static economics.

The rate of discount or yield i.e., r is conventionally called the Marginal Efficiency of Investment (MEI). Keynes originally called it the ‘Marginal Efficiency of Capital’. Brooman says that it is preferable to use a term which refers explicitly to investment (i.e., MEI). The MEI (or MEC) ought to be distinguished from the ‘Marginal product of capital’ which refers to the increase in current output resulting from the addition of one more unit of capital.

It is clear that the marginal product of capital is a physical quantity similar to the marginal product of any other factor. The MEI is a percentage rate, and not the physical quantity. Again the marginal product of capital does not involve expectations about the yield from the unit of capital during the remainder of its life. But the MEI is very much concerned with such expectations about the yield.

Strictly speaking, however, there is a difference between the MEC and the MEI. The MEC is derived as the relationship between i (rate of interest) and the optimum level of capital stock. The MEI is derived as the relationship between i (rate of interest) and the optimum change in capital stock. It can be said by way of corollary that the MEC and the MEI are interrelated.

The MEI really indicates the decision to invest whereby there is change in the capital stock. This relationship between investment as the change in capital stock and the actual capital stock presents a difficulty in determining the MEI. If investment is change in capital stock, it can be assumed that the capital stock is fixed once investment is underway.

Keynes recognized this difficulty and sought to overcome it by stating that he was interested in short period changes in investment. In the short period change in investment would be insignificant relative to the entire capital stock; therefore, the impact of investment on capital stock could be ignored.