Marginal Efficiency of Capital

Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority and you can order it here)

That rate of discount which equates present value of net expected revenue from an investment of capital to its cost; a Keynesian concept.  The concept plays a major role in the Keynesian theory of investment; the level of investment is determined by the marginal efficiency of capital relative to the rate of interest.  If the marginal efficiency rate is higher than the rate of interest, investment will be stimulated; if not, investment will be discouraged.  A fall in the rate of interest will stimulate investment, assuming the decline is below the given marginal efficiency rate.  Marginal efficiency returns should then rise (based on higher anticipations of returns from investment), and such rise above a given prevailing rate of interest will stimulate investment.

The concept is based on the ordinary mathematical technique of computing present value of a given series of returns discounted at a specified discount rate.  If an investment in equipment cost $4,450 and is expected to yield returns of $1,000 per year for five years, such returns,

will equate with the cost of $4,450 for the investment if the rate of discount (marginal efficiency of capital) is 4%.  If the prevailing interest cost of money to finance such investment is actually below 4%, the investment will be stimulated; if it is above 4%, the investment will be discouraged.

In income-expenditure analysis, the marginal efficiency of capital is a price factor in determining whether businesses are going to borrow and invest.  The rate of interest is a passive factor because businesses do not borrow merely because the interest rate is low.  A stable and material gap between the marginal efficiency of capital and the rate of return will result in an increase in the level of economic activity.

The marginal efficiency of capital is determined to some extent by the expectation of profits compared to the replacement cost of capital assets.  The marginal efficiency of capital can ordinarily be improved by an increase in productivity, sales, or prices, or by a decrease in the costs of production.  Generally, it is the relationship between the marginal efficiency of capital and the rate of interest that causes expansion, equilibrium, or contraction in the economy.

The term net expected revenue anticipations refers to net return over depreciation.  Productivity theories of investment and their justification of interest date back at least to the work of the famous Austrian Bohm-Bawerk and the early work of Dr. Irving Fisher of Yale, but in the Keynesian schema the marginal efficiency of capital was adapted as one of the three major aspects of the Keynesian model, the other two being the liquidity preference concept of determination of interest rates and the consumption function.  

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