Marginal efficiency of capital

1. Marginal efficiency of capital

2. Introduction In 1920 Irving Fisher was first economist to make use of concept MEC He gave it a name Rate of return over Cost. In simple word, MEC means “ expected rate of profitability of new investment” Its calculation depends upon 2 factors: Amount of profit, expected by investing one more unit of capital. Cost of capital asset. MEC can also b calculated by deducting its cost from total assets.

3. EXAMPLE: Suppose the price of machine is 30000.Duration of life of machine is 10 years, expected income during this period is 60000. NOW Total Profit of machine is 60000-30000= 30000 Average profit per year - 30000/10 = 3000 MEC = 3000/30000 *100= 10%

4. definitions In the words of Kurihara , “ MEC is the ratio between the prospective yield of additional capital goods and their supply price” In the words of W.C. Peterson , “ The rate of return over cost relates the expected yield of a capital good to its supply price . It is the relationship that Kyenes calls MEC.

5. DETERMINANTS OF MEC There are 2 determinants of MEC :- 1. Prospective Yield • It is the aggregate net return expected from it during its whole life. • With rise in price , prospective yield increases and with the fall in price ,it decreases.

6. Supply Price • It is the cost of producing a new asset of that kind , not the supply price of an existing asset. • It is also called Replacement Cost.

7. DETERMINATION OF MEC Keynes has explained MEC as a discount rate which makes the prospective yield of a capital asset equal to its supply price Supply price = Discounted prospective yield SP= Py1 + Py2 + Py3 +………..+ Pyn (1+m) (1+m)² (1+m)³ (1+m) if life time of a machine is n year and total prospective yield is Py , then SP= Pynor (1+m)n SP= Py (1+m) Or (1+m)n = Py SP Where m- MEC

8. MEC SCHEDULE It is a schedule which expresses relationship between amount of investment and MEC

9. MEC/ROI R R1 O M M1 INVESTMENT

10. Causes of decline in mec • Reduction in Selling Prices When more investment is made in production of commodity, supply of commodity tends to increase. As a result its prevailing market price begins to fall. In this way prospective yield also falls . Consequently , MEC of capital begins to decline . • Increase in Cost of Production Increased investment of a particular type raises their demand for a particular type of capital asset raises its demand and hence its supply increases. Other things remaining constant higher the supply price, lower the MEC . • Diminishing Productivity As a result of increase in capital stock, principal of diminishing productivity begins to operate. Use of every additional unit of capital is followed by diminishing physical production. Thus prospective yield and MEC fall despite price remaining constant.

11. MEC AND RATE OF INTEREST An investor while taking investment decision makes a comparison between MEC and rate of interest. • When rate of interest is less than MEC ( ROI< MEC) investor makes more investment • When rate of interest is equal to MEC (ROI= MEC) investor stop making any more investment • When rate of interest is more than MEC (ROI> MEC) no investment will be made