Which Marginal Efficiency of Capital Depends:
J .M. Keynes, the volume of new investment
depends on the following two factors:
Marginal Efficiency of Capital (MEC).
Market Rate of Interest.
The producer's decision as to whether or not, he
should undertake a given investment project is arrived at by comparing marginal
efficiency of capital (MEC) with the market rate of interest (or the cost of
Marginal Efficiency of Capital:
efficiency of capital is the expected annual rate of return on an additional
unit of a capital good. It is also described as the rate of return expected to
be received on money if it were invested in a newly produced asset. According to
"The marginal efficiency of capital is the rate of discount which
makes the present value of the prospective yield from the capital asset equal to
its supply price. The marginal efficiency of capital will progressively diminish
as investment in the asset increases. The marginal efficiency of capital (MEC)
curve is, therefore negatively sloped".
The marginal efficiency of capital is influenced by short
run as well as long run factors. These factors are now discussed in brief:
(i) Demand for the product. It the market for a particular good
is expected to grow and its costs are likely to fall, the rate of return from
investment will be high. If entrepreneurs expect a fall in demand of goods and a
rise in cost, the will decline.
(ii) Liquid assets. If the entrepreneurs are holding large
volume of working capital, they can take advantage of the investment
opportunities that come in their way. The MEC will be high and vice versa.
(iii) Sudden changes in income. The MEC is also influenced by
sudden changes in income of the entrepreneurs. If the business community gets
windfall profits, or there are tax concession etc., the MEC will be high and
hence investment in the country will go up. On the other hand, MEC falls with
the decrease in income.
(iv) Current rate of investment. Another factor which influences MEC is the current date of investment in a particular industry. If in a
particular industry, much investment has already taken place and the rate of
investment currently going on in that industry is also very large, then the
marginal efficiency of capital will be low.
Wave of optimism and pessimism. The marginal efficiency of
capital is also affected by waves of optimism and pessimism in the business
circle. If businessmen are optimistic about future, the MEC will be
overestimated. During periods of pessimism the MEC is under estimated.
run factors which influence the marginal efficiency capital are as under:
(i) Rate of
growth of population. Marginal efficiency of
capital is also influenced by the rate of growth of population. If population is
growing at a rapid speed, it is usually believed that at the demand of various
classes of goods will increase. So a rapid rise in the growth of population will
increase the marginal efficiency of capital and a slowing down in its rate of
growth will discourage investment and thus reduce marginal efficiency of
development. If investment and technological
development take place in the industry, the prospects of increase in the net
yield brightens up. For example, the development of automobiles in the 20th
century has greatly stimulated the rubber industry, the steel and oil industry,
etc. So we can say that inventions and technological improvements encourage
investment in various projects and increase marginal efficiency of capital.
(iii) The quantity of
capital goods of relevant types already in
existence. If the quantity of any particular of goods is available in abundance
in the market and the consumers can partially or full meet the demand, then it
will not be advantageous to invest money in that particular project. So in such
cases, the marginal efficiency of capital will be low.
(iv) Rate of
taxes. Marginal efficiency of capital is directly
influenced by the rate of taxes levied by the government on various commodities,
When taxes are levied, the cost of commodities is increased and the revenue is
When profits are reduced, marginal efficiency of capital
will naturally be affected. It will be low.