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Marginal Efficiency of Capital (MEC)
It refers to the expected rate of profit or the return from investment over its cost. It is the highest return that can be yielded from the additional unit of the capital asset. It was first introduced by J.M Keynes in 1936 in order to analyze the profitability of the prospect ventures. It is based on two factors:
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 Q1, Q2, Q3… Qn 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;
R1 + R2 + … + Rn = 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= $ 3000Expected Yield (first year) = $1100
Expected Yield (Second year) = $1210
Then, marginal efficiency of capital (r) is calculated as
SP= R1/ (1+r) + R2/ (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
1. When the expected yield increases to Rn, rate of discount increases
2. 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.
Decision Rule: Once MEC of the capital is estimated, investment decision is made by comparing with the market rate of interest.
i. If MEC>r, then the investment project is acceptable.
ii. If MEC=r, then the project is acceptable on non-profit consideration.
iii. If MEC
Factors causing a shift in the Marginal Efficiency of Capital
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.
Marginal Rate of Investment (MEI)
It is the rate of return expected from a unit of investment. It is the expected rate of return on investment as additional units of investment are made under specified conditions and over a period of time. Investment is attractive only if the MEI's higher than the market rate of interest.
Difference between MEC and MEI
| MEC | MEI |
| It is based on given supply price for capital. | It is based on the induced change in the price due to the change in demand for capital. |
| It represents rate of return on all successive units capital without regard to existing capital. | It represents the rate of return on just those units of capital and above the existing capital. |
| In MEC, the capital stock is taken on the horizontal axis of diagram. | In MEI, the amount of investment is taken on the horizontal axis of the diagram. |
| It is a stock concept. | It is a flow concept. |
| It determines the optimum capital stock in an economy at each level of interest rate. | It determines the net investment of the economy at each interest rate given the capital stock. |
Some parts are adopted from: www.businesstopia.com
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