Marginal Efficiency of Capital (MEC)

Keynes's Definition: MEC is the rate of discount that makes the present value of the expected stream of returns from a capital asset equal to its supply price.

In simpler terms: MEC = Expected rate of profit on an additional unit of investment

Formula concept: If a firm invests ₹1,00,000 in a machine and expects to earn ₹15,000 per year, then (roughly) MEC = 15%.

More precisely, MEC is the internal rate of return (IRR) such that: Supply Price = Sum of [Qr / (1+i)^r] Where:

• Qr = prospective yield in year r
• i = MEC (the discount rate to be found)
• Supply price = cost of the asset

Investment will be undertaken as long as MEC > rate of interest (r). Investment is not worthwhile when MEC < rate of interest.

1. Expected profitability: Higher expected profits → higher MEC → more investment

2. Supply price of capital: Higher the cost of the capital good → lower the MEC

3. State of expectations (business confidence): Optimistic business outlook → higher MEC; pessimism → lower MEC

4. Technological change: New, more productive technology raises MEC

5. Stage of business cycle: MEC rises in economic booms (high demand, high profits); falls in recessions

6. Rate of capital accumulation: As more investment occurs and supply of capital goods rises, supply price increases → MEC declines

The relationship between MEC, rate of interest (r), and investment:

If MEC > r: Investment is profitable. Firms will invest — expected returns exceed borrowing cost. If MEC = r: Equilibrium. No incentive to invest more or less. If MEC < r: Investment is not worthwhile. Expected returns are less than borrowing cost.

MEC Schedule / MEC Curve:

• As more capital is accumulated, MEC declines (diminishing marginal returns)
• The MEC curve slopes downward to the right
• The intersection of MEC curve and the interest rate line determines equilibrium investment

Keynes's argument: During a recession, the rate of interest can be reduced (monetary policy) to stimulate investment by making more projects MEC > r.

MEC (Marginal Efficiency of Capital):

• Assumes supply price of capital goods remains constant
• Focuses on an individual firm's investment decision
• Does not account for economy-wide increases in capital goods prices when all firms invest

MEI (Marginal Efficiency of Investment):

• Account for rising supply prices of capital goods when the entire economy invests
• As aggregate investment increases, demand for capital goods rises → supply prices rise → MEC falls further
• MEI curve is steeper than MEC curve
• MEI is more relevant for macroeconomic investment analysis