According to J.M. Keynes, the marginal efficiency of capital (MEC) or volume of new investment depends on the following two factors:
The marginal efficiency of capital is influenced by short run as well as long run factors. These factors are now discussed in brief:
Short Run Factors:
The short run factors which influence the marginal efficiency capital or new investment are as under:
(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.
(v) 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.
Long Run Factors:
The long run factors which influence the marginal efficiency capital or new investment 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 capital.
(ii) Technological 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 lowered.
When profits are reduced, marginal efficiency of capital or new investment will naturally be affected. It will be low.