Marginal efficiency of capital and marginal efficiency of investment
Keynes, in his General Theory, developed the concept of the marginal efficiency of capital (MEC). MEC
uses the expected return from investment and the supply price of capital in order to give us an idea about
the way a firm should evaluate a decision to invest or not. Strictly speaking,
MEC is that rate of discount, which, if applied to the stream of future expected returns from an
investment decision, will just equal the present discounted value of such returns to the supply price
for that capital stock.
Mathematically, MEC is that rate of discount δ that satisfies the equation:
C = R1 /(1 + δ) + R2 /(1 + δ)2 + R3 /(1 + δ)3 + ............... + Rn /(1 + δ)n ....................... (1)
In (1), C is the supply price of capital.
Firms should invest in the capital good if MEC > r (the current market rate of interest) and desist from
investing if r > MEC. The underlying logic is quite simple: MEC is a measure of the expected return from
capital, while r is a measure of the cost of capital. So, if the return (MEC) is greater than the cost(r), it
makes sense to invest.
Slope of MEC: It is assumed that other things remaining equal, the MEC declines as the stock of capital
(K) increases. The reasons why MEC may decline are: first, the stock of other factors (say labour)
remaining constant, their remuneration (like, say, wages) might go up and reduce the net return from
capital. Secondly, if all labour is employed, MP K will go down with higher amounts of K. Also, as more of the
final output is now being produced (with higher quantities of K), its price may also go down, again reducing
the return for the investor. This is shown in figure 1.
MEC, r
Fig 1
E
F
MEC
The MEC is not really a theory of investment. It is rather a theory of the determination of firm’s
optimal capital stock. For a theory of investment, we need to know the current actual stock of capital.
Why? Because investment is a flow concept – it gives us the addition to capital stock per unit of time.
*
So, we need to know the current stock of capital (say, K 1), the desired or optimum stock of capital (say K )
and also the changes in C - the supply price of capital, as firms demand more and more of K. We make the
standard assumption that, like other goods, the capital goods supply schedule too is positively sloped.
Now, if the price of K rises as more investment is made (to reach a certain optimum stock of capital), it is
clear that the optimum stock of capital will be somewhat less than what was originally calculated. This is
because a rise in C will reduce MEC. Therefore, what was the optimum planned stock at the current
rate of r will no longer be the optimum stock at the same r (but higher C). The concept is clarified in
fig 2(a) and 2(b).
MEC, r
Fig 2 (a)
6% E
5% F
MEC
100 150 K
*
5% K - K1
Fig 2 (b) MEI
30 50 I
*
When the rate of interest falls from 6% to 5%, the desired change in optimum capital stock is 50 units (K
goes up to 150 from 100). However, when investment is made, C goes up and the rates of return on
successive capital units fall. Thus, the firm does not find it optimum to buy 50 units of capital, but stops
*
earlier (say, at 30 units). This is reflected in fig 2(b). [Somewhat inaccurately drawn as the K - K1
schedule and the MEI schedule should coincide at point A, and not at any other point].
We conclude this discussion with two further observations. First, the fundamental differences between
MEC and MEI.
Point of MEC MEI
Difference
SUPPLY PRICE Based on a given supply price Takes into account induced
OF CAPITAL changes in supply price
RATE OF Does not regard the Shows rate of return on only
RETURN existing capital stock while those units of capital over
representing return on all and above the existing
successive capital stock capital stock
Secondly, we note that the MEI schedule will shift as the existing capital stock changes. Starting from
the example showed in figures 2(a) and 2(b), we noted that the firm made an investment of 30 units of K in
period 1 when faced by a 5% rate of interest. So the existing stock of capital becomes 130 at the start of
period 2 (at the start of period 1, it was 100), and at this value of K, the MEI must be different (lower
than the earlier one). Say the new MEI is called MEI2.
6%
5%
Fig 3 MEI1
MEI2
15 30 I
Now, at 5% interest (assuming that r does not change), optimum investment in period 2 should be 15 units
and the capital stock at the start of period 3 should be 145 units. Then there will be another downward
shift in the MEI schedule.
From the above discussion, we learn that investment is dependent both on the rate of interest as well as
on the size of the existing capital stock. Writing this in functional form, we find:
I= i (r, K)
