Concept of Marginal Efficiency of Investment
The marginal efficiency of investment is the rate of return expected from a given investment on a capital asset after covering all its costs, except the rate of interest. Like the MEC, it is the rate which equates the supply price of a capital asset to its prospective yield. The investment on an asset will be made depending upon the interest rate involved in getting funds from the market. If the rate of interest is high, investment is at a low level.
A low rate of interest leads to an increase in investment. Thus the MEI relates the investment to the rate of interest. The MEI schedule shows the amount of investment demanded at various rates of interest. That is why, it is also called the investment demand schedule or curve which has a negative slope, as shown in Fig. 1(A). At Or1 rate of interest, investment is OF. As the rate of interest falls to Or2, investment increases to ОI”.
To what extent the fall in the interest rate will increase investment depends upon the elasticity of the investment demand curve or the MEI curve. The less elastic is the MEI curve, the lower is the increase in investment as a result of fall in the rate of interest, and vice versa.
In Figure 5 the vertical axis measures the interest rate and the MEI and the horizontal axis measures the amount of investment. The MEI and MEI’ are the investment demand curves. The MEI curve in Panel (A) is less elastic to investment which increases by I’I’’. This is less than the increase in investment I1I”2 shown in Panel (B) where the MEI’ curve is elastic. Thus given the shape and position of the MEI curve, a fall in the interest rate will increase the volume of investment.
On the other hand, given the rate of interest, the higher the MEI, the larger shall be the volume of investment. The higher marginal efficiency of investment implies that the MEI curve shifts to the right. When the existing capital assets wear out, they are replaced by new ones and level of investment increases.
But the amount of induced investment depends on the existing level of total purchasing. So more induced investment occurs when the total purchasing is higher. The higher total purchasing tends to shift the MEI to the right indicating that more inducement to investment takes place at a given level of interest rate.
This is explained in Figure 2, where MEI1 and МЕI2 curves indicate two different levels of total purchasing in the economy. Let us suppose that the MEI, curve indicates that at Rs 200 crores of total purchasing, OI1 (Rs 20 crores) investment occurs at Or1 interest rate. If total purchasing rises to Rs 500 crores, the MEI1 curve shifts to the right as МЕI2 and the level of induced investment increases to OI2 (Rs 50 crores) at the same interest rate Or1.
Distinction between MEC and MEI
Keynes did not distinguish between the marginal efficiency of capital (MEC) and the marginal efficiency of investment (MEI).
But modern economists have made clear distinctions between the two concepts as follows:
(i) The MEC is based on a given supply price for capital, and the MEI on induced changes in this price.
(ii) The MEC shows the rate of return on all successive units of capital without regard to the existing stock of capital. On the other hand, the MEI shows the rate of return on only units of capital over and above the existing stock of capital.
(iii) In the MEC, the capital stock is taken on the horizontal axis of a diagram, while in the MEI the amount of investment is taken horizontally on the X-axis.
(iv) The MEC is a ‘stock’ concept, and the MEI is a ‘flow’ concept.
(v) The MEC determines the optimum capital stock in an economy at each level of interest rate. The MEI determines the net investment of the economy at each interest rate, given the capital stock.