MARGINAL EFFICIENCY OF CAPITAL

The marginal efficiency of capital means the expected rate of profit, the expected rate of return over cost or the expected profitability of a capital asset. It is the highest rate of return over the cost expected from an additional or marginal unit of that capital asset. It is expressed as the ratio between the prospective yields of additional capital assets and their supply price. Symbolically,   e= Q/P, where, e is the marginal efficiency of capital, Q is the expected yield of return of a capital asset for a unit of time, and, P is the supply price of this asset.  


The marginal efficiency of capital depends upon the prospective yield from the capital asset and the supply price of this asset. The term ‘prospective yield’ refers to the amount of annual income an investor expects to obtain from selling the output of his investment or capital assets after deducting the running expenses for obtaining that output during its life-time. The supply price of the capital asset is the price the entrepreneur has to pay to acquire it. It is also called the ‘replacement cost’. Keynes relating the prospective yields and the supply price of the capital asset arrives at a precise definition of the marginal efficiency of capital as ‘being equal to that rate of discount which would make the present value of the series of annuities given by the return expected from the capital asset during its life just equal to its supply'. A change in the prospective yields directly affects the MEC and a change in the supply price inversely affects it. The marginal efficiency of capital may change either because the cost changes or because the amount of return changes. Thus, the marginal efficiency of capital is the rate at which the prospective yield from an asset must be discounted to bring into equality with the supply price or replacement cost of the capital asset.

FACTORS INFLUENCING MARGINAL EFFICIENCY OF CAPITAL

There are several factors affecting the marginal efficiency of capital.

1. Expectations about the Course of Demand, Price and Cost of Production: 
 If the business community expects demand for products to rise and their prices to rise more than their costs, a high MEC which would stimulate investment activity. If, however, entrepreneurs anticipate the demand to decline and prices to fall against a stead cost of production, a declining MEC will be estimated.

2. Business Optimism and Pessimism: 
 Business psychology plays an important role in determining the MEC. If there is an atmosphere of business optimism a majority of entrepreneurs would estimate a high or improved MEC. Under depressed atmosphere, a low MEC is estimated.

3. Propensity to Consume:  
When there is a shift in the consumption function, the increased demand for consumption goods will increase the derived demand for capital goods. This causes a high MEC anticipation.

4. Change in Income:  
Any windfall gain, tax reduction or such other factors may suddenly raise the level of income. This would encourage demand and consumer’s outlay, so the MEC will tend to rise.

5. Change in Liquid Assets: 
 If entrepreneurs hold a large volume of liquid assets of various kinds, they can take advantage of the forthcoming investment opportunities very easily, hence the MEC will be relatively high.

6. Technological Advancements:  
With the growth of scientific inventions and technological changes, new products, new methods of production, new markets, etc. may be developed, which have a favorable impact on the MEC in he long run.