Concept Of Marginal Efficiency Of Capital (MEC)-Economics Exposed

Marginal efficiency of capital
Marginal Efficiency Of Capital (Mec) Is A Keynesian Concept According To J M Keynes Nations Output Depends On Its Stock Of Capital An Increase In The Stock Of Capital Increases Output The Question Is How Much Increase In Investment Raises Output Well This Depends On The Productivity Of New Capital I E On The Marginal Efficiency Of Capital Marginal Efficiency Of Capital Is The Rate Of Return Expected To Be Obtainable On A New Capital Asset Over Its Life Time.J. M. Keynes Defines Marginal Efficiency Of Capital As The Rate Of Discount Which Makes The Present Value Of The Prospective Yield From The Capital Asset Equal To Its Supply Price

A Businessman While Investing In A New Capital Asset Examines The Expected Fate Of Net Return (Profit) On It During Its Lifetime Against The Supply Price Of Capital Asset (Cost Of Capital Asset) If The Expected Rate Of Profit Is Greater Than The Replacement Cost Of The Asset The Businessman Will Invest The Money In The Project For Example If A Businessman Spends Rs 10,000 On The Purchase Of A New Griding Machine We Assume Further That This New Capital Asset Continues To Produce Goods Over A Long Period Of Time The Net Return (Excluding Meeting All Expenses Except The Interest Cost) Of The Griding Machine Is Expected To Be Rs. 1000 Per Annum The Marginal Efficiency Of Capital Will Be 10%.
1000          100
10000
₁ – 10%.
^x
The Following Formula Is Used To Know The Present Value Of Series Of Expected Income Throughout The Life Span Of The Capital Assets.
_R1          R2
P         1+r       l+r                      1-1-rⁿ
S, = Stands For Supply Price Of The New Capital Asset
_Ri _{4. R}2
Rn = Stands For Returns Received On Yearly Basis.

R = It Is The Rate Of Discount Applied In Each Of The Years

Schedule Of Marginal Efficiency Of Capital
According To J M Keynes The Behaviour Of Investors In Respect Of New Investment Depends Upon The Various Stocks Of Capital Available In The Economy At A Particular Period Of Time As The Stock Of Capital Increases In The Economy The Marginal Efficiency Of Capital Goes On Diminishing The Mec Curve Is Negatively Sloped As Is Shown In The Figure 30.7

Investment                                                       Marginal
                                                                      efficiency of
                                                                           capital

(Rs.  Billion)

20                                                                        10%

25                                                                        9%

40                                                                        7%

70                                                                         5%

100                                                                       2%

In The Above Table, It Is Shown When Stock Of Capital Is Equal To Rs. 20 Billion, The Marginal Efficiency Of Capital Is 10%. While At A Capital Stock Of Rs 100 Billion, It Declines To 2%. This Investment Demand Schedule When Depicted Graphically In Figure 30.7 Gives Us The Investment Demand Curve Which Goes On Sloping Downward From Left To Right.
Relative role of MEC and the rate of interest.
The MEC And The Rate Of Interest Are The Two Important Factors Which Affect The Volume Of New Investment In A Country. An Investor While Making A New Investment, Weighs The MEC Of New Investment Against The Prevailing Rate Of Interest As Long As The Mec Is Higher Than The Rate Of Interest, The Investment Will Be Made Till The MEC And The Rate Of Interest Are Equalized For Example, If The Rate Of Interest Is 7%, The Induced Investment Will Continue To Be Made Till The Mec And The Rate Of Interest Are Equalized. At 7% Rate Of Interest, The New Investment Will Be Rs. 40 Billion. In Case, The Rate Of Interest Comes Down To 2%, The New Investment In Capital Assets Will Be Rs. 100 Billion. Summing up, if Investment Is To Be Increased In The Country. Either The Rate Of Interest Should Go Down Or Mec Should Increase.
The Investment Demand Function Is Expressed As Under.
I = f(i, r), where i = investment demand, i = Rate of interest and r = expected rate of return or MEC.