# Marginal Efficiency Of Capital

Last Updated :

21 Aug, 2024

Blog Author :

Aswathi Jayachandran

Edited by :

Raisa Ali

Reviewed by :

Dheeraj Vaidya

Table Of Contents

**What Is The Marginal Efficiency Of Capital?**

The marginal efficiency of capital (MEC) refers to the expected rate of return on an additional unit of capital investment in the production process. It measures the ability of an investment to generate additional income, taking into account all relevant factors, such as market conditions, competition, and technological advancements.

The concept of the "marginal efficiency of capital" was introduced by John Maynard Keynes in his book "The General Theory of Employment, Interest, and Money," published in 1936. He saw MEC as a crucial factor in determining the level of aggregate investment in the economy and its impact on economic growth and employment.

##### Table of contents

- The marginal efficiency of investment refers to the expected rate of return on an additional unit of investment made within certain parameters and over a given time frame.
- The rate of return is calculated as the expected additional return from an investment project for a given unit of investment.
- Several short- and long-term factors influence MEI. Therefore, forecasting these values helps greatly in efficiently planning and deploying funds for investment.

**Marginal Efficiency Of Capital Explained**

Marginal efficiency of investment refers to the expected rates of return on investments when additional investment is made within certain parameters and over a given time frame. It is possible to determine the investment's profitability by comparing these rates with the market interest rate. The rate of return is calculated as the amount that must be deducted from the anticipated stream of future returns from an investment project for their current value to equal the project's cost.

According to Keynes, "the marginal efficiency of capital" is defined as the rate of discount that would bring the supply price of a capital asset's supply exactly into line with the present value of the series of annuities that would result from the returns expected from the asset over its expected lifetime. He adds that the supply price of the asset should not be confused with its current price but rather with the price that would merely motivate a producer to create an additional unit of such assets, i.e., it is frequently called its replacement cost.

**Factors**

The marginal efficiency of capital (MEC) is influenced by several factors, including:

**Technological progress:**New technologies can increase the productivity of capital, leading to an increase in MEC.**Competition:**Competition among firms can lead to a reduction in the rate of return on investment, reducing MEC.**Expectations:**The expectations of investors about future market conditions can impact MEC. If investors expect high profits, MEC will be high, and investment will increase.**Interest rates:**Higher interest rates increase the cost of borrowing, lowering MEC.**Time preference:**The time preference of investors, i.e., their preference for current consumption over future consumption, can impact MEC.**Risk:**The perceived risk of an investment can influence MEC, as investors will require a higher rate of return to compensate for the risk.**Availability of investment opportunities:**If investment opportunities are abundant, MEC will be high, and investment will increase.

These factors interact and can affect MEC fluctuations, impacting investment and economic growth.

### Formula

Here,

Sp: Supply price or the cost of the capital asset

R1,R2… Rn: Series of expected annual returns from the capital asset in the years 1,2…….n

i: Rate of discount

**Calculation Example**

The lifetime of a capital asset (n) is two years.

The supply price (Sp) is $10,000

The expected yield at the end of a year (R1) is $5,500

The expected yield at the end of 2 years (R2) is $6,050

The commodity worth $10,000 is predicted to provide an annual yield of $1,000. Then, 10% will be the marginal efficiency of capital:

(1000/10,000) X (100/1) = 10%

Here, the rate of discount "i" or MEC equals the two sides of the equation. For example, a new capital asset with a supply price of $ 10,000 and a two-year life is anticipated to generate $5,500 in the first year and $6,050 in the second. Therefore, the marginal efficiency of capital (MEC), or the rate of discount that balances the expected future returns of the asset with its cost price, is 10%. It is demonstrated as follows:

### Marginal Efficiency Of Capital vs Marginal Efficiency Of Investment

The concepts of the marginal efficiency of capital (MEC) and the marginal efficiency of investment (MEI) are related to the expected rate of return on investment. Both play a role in helping businesses make investment decisions that are expected to generate profits. However, they have different focuses and use different information to do so.

Major differences between the marginal efficiency of capital and investment are as follows:

Points | Marginal Efficiency of Capital (MEC) | Marginal Efficiency of Investment(MEI) |

Meaning | The MEC is a concept that describes the expected rate of return on investment, given the supply price of capital. | The MEI is the expected rate of return on investment for additional units of investments made over a period, given the induced changes in demand for capital. |

What it does | The MEC determines the expected rate of return on investment and helps to determine the optimal level of investment in the economy. | The MEI helps to determine the net level of investment in the economy, given the expected returns on investment and changes in demand for capital. |

The measuring component | The MEC measures the expected rate of return on an investment relative to the cost of investment. | The MEI measures the return on investment for a firm or the economy as a whole, given changes in demand for capital. |

Determinants | The determinants of the MEC include the expected returns on investment, the productivity of capital goods, and the supply price of capital. | The MEI's determinants include the firm's production function, the demand for its output, and changes in the demand for capital. |

### Frequently Asked Questions (FAQs)

**What are the functions of the marginal efficiency of capital?**The marginal efficiency of capital (MEC) has several important functions in economics and investment analysis, including investment decisions, optimal capital stock, interest rate analysis, capital budgeting, and macroeconomic analysis. In essence, the MEC plays a significant role in investment analysis and decision-making, as well as in macroeconomic analysis and policy formulation.

**What are the limitations of the marginal efficiency of capital?**The marginal efficiency of capital (MEC) is useful for analyzing the expected returns on investment, but it is not without limitations. Some of the disadvantages of MEC include its simplistic assumptions, difficulty in measurement, limited usefulness in short-run analysis, and it does not account for externalities.

**What are some of the fields and organizations that commonly use the marginal efficiency of capital (MEC)?**Economists widely use MEC, investors, financial analysts, firms, and government agencies to evaluate investment opportunities, make investment decisions, and analyze economic conditions and trends.

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