Marginal Efficiency of Capital (MEC) and Investment Demand Function
Businessmen and entrepreneurs are induced to make an investment when the return on investment is attractive. Before investing, businessmen compare the yield from the investment and the cost incurred in making the investment. It is only when the return is greater than cost, investment is made.
Producing in a capitalist economy, profit is the primary objective of business firms and manufacturing companies. So in order to maximize their profit, they seek to invest in those ventures that yield higher profit. Keynes introduced the concept of marginal efficiency of capital in order to analyze the profitability of the prospect ventures.
Generally, marginal efficiency of capital or MEC refers to the expected rate of profit or the rate of return from investment over its cost. Marginal efficiency of a given capital asset is the highest return that can be yielded from the additional unit of that capital asset.
Keynes defined MEC as ‘The rate of discount which makes the present value of the prospective yield from the capital asset equal to its supply price’.
Thus, Keynes’ marginal theory of capital is bases on two factors that include
1. Prospective yield from capital assets
The term prospective yield is the aggregate net return the investor expects to receive on the sale of capital assets after the deduction of running costs incurred for the purchase of capital assets considering its total expected life.
Usually, when the total expected life of the capital asset is divided into a series of periods, generally years, the annual return is determined. This is represented as Q_{1}, Q_{2}, Q_{3}… Q_{n} and are termed as annuities.
2. Supply price of this asset
The investor has to consider the supply price of asset that he is planning on investing. Supply price of asset refers to the cost incurred for the acquisition of the capital asset. Here, the cost incurred is for the purchase of or production of a new asset and not the price of any of the existing assets.
The present value of a series of expected income from the invested capital asset throughout its life span is expressed as
Where,
SP= Supply price of new capital asset;
R^{1} + R^{2} + … + R^{n} = Return received annually;
r= Rate of discount applied each year;
R/ (1+r) = Current value of annuity discounted at rate r.
The concept of marginal efficiency of capital can be illustrated with a numerical.
For instance,
Expected lifespan of capital asset= 2 years
Supply price of capital asset= $ 3000
Expected Yield (first year) = $1100
Expected Yield (Second year) = $1210
Then, marginal efficiency of capital (r) is calculated as
SP= R^{1}/ (1+r) + R^{2}/ (1+r)^{2}
2000/ (1+r) = 1100/ (1+e)^{2} + 1200
Thus, r= 10%
Taking r= 1/10
SP= 1100 + 1100/ (1+1/10) = 1000 + 1000/ (1+1/10)^{2 }= 2000
From the above calculation, we can it may be observed that
- When the expected yield increases to R^{n}, rate of discount increases
- Rate of discount or MEC decreases when supply price of capital asset increases with a given amount of expected annual return on capital asset, and vice versa.
Thus, prospective yields have a direct effect on MEC whereas, supply price has an inverse effect. This means that the rate of return over cost may vary as a result of changes in cost or change in the amount of return. Investors would be willing to make investments only when the return from prospective capital investment is greater than the supply price.
Investment Demand Function
According to J.M. Keynes, investment depends on the market rate of interest and the marginal efficiency of capital. A schedule that shows the relation between interest rates and marginal efficiency of capital is termed as investment demand schedule.
A hypothetical schedule can be prepared that shows the investment demand at varying levels of interest rates and the effect that marginal efficiency of capital has on the demand:
Rate of Interest ( % p.a) |
Volume of Investment Demand ($) |
Marginal Efficiency of Capital (MEC) |
10 |
10 |
10 |
9 |
20 |
9 |
8 |
30 |
8 |
7 |
4 |
7 |
6 |
50 |
6 |
5 |
60 |
5 |
From the schedule, it can be observed that investment demand rises as interest rate falls. Generally, investment is attractive when the rate of interest is lower. When the rate of interest is 5%, the investor would expect a return of at least 5% on the investment.
In case the marginal efficiency of capital is lower than the current rate of interest, investors would rather save than make an investment.
The diagrammatical representation of the investment demand curve gives a curve which is known as the investment demand function or the marginal efficiency of capital curve.
As seen in the diagram, the volume of investment has increased with the decrease in the rate of interest. Generally, on average, the investment demand curve is inelastic. So, the change in rate of interest has very minimum effect on the volume of investment.
However, a more important concept to consider is the shift in the investment demand curve. Keynes, states that rate of interest is relatively constant in the short run, but MEC is highly fluctuating. So, the investment demand function and the volume of investment moves along with the increases or decrease in the MEC.
The diagram shows that with the change in the marginal efficiency of capital, the investment demand curve shifts upward or downwards although the rate of interest remained unchanged.
Factors causing a shift in the Marginal Efficiency of Capital/ Investment Demand Function
There are a number of factors that are responsible that cause a shift in the investment demand function. Some of the most prominent factors include:
Cost of capital
If the cost of capital is cheaper, investment is more attractive and vice versa.
Change in technology
Changes in technologies can make investments more attractive with attractive future returns on investments made in the technological sector.
Demand for goods and services
Increase in demand for goods and services increase the profitability of the companies, and in return, increase the profitability of capital investments.
Tax rates
The tax rates imposed by the government affects the volume of investment. Higher taxes discourage investment while the government sometimes offers tax breaks to boost investment in the economy.
Facilities for finance
If the financial institutions provide easy loan and other facilities at relatively low interest rates, it boosts investment.
Future trade expectations
If any business venture has good future prospect towards profitability, it encourages investment in those business sectors that yield higher rates of return in the future.