DETERMINATION OF MARGINAL EFFECIENCY OF CAPITAL
Meaning of Marginal Efficiency of Capital Irving Fisher, 1930 was the first economist who made use of the concept of marginal efficiency of capital. He gave it the name of Rate of Return over Cost. In simple words, marginal efficiency efficiency of capital means: expected rate rate of possibility of new investment. Term efficiency has been used to mean µRate of Income.¶ In other words, marginal efficiency of capital means income received after deducting the cost from the return of an a n additional unit of capital. Its calculation depends on two factors: i) The amount of profit which is expected by investing one more unit of capital asset and ii) cost of capital asset. M.E.C. can be calculated by deducting from total income of capital asset its cost. Suppose the price of a machine is Rs. 40,000. The duration of life of this machine is 20 years. During this period it is expected to yield an income of Rs. 70,000. Thus the total profit of machine is Rs.70,000- Rs. 40,000 = Rs. 30,000 only. only. Hence profit per year will be Rs.30,000/20 = Rs. 1500. This profit is earned on o n an investment of Rs.40,000, M.E.C. is therefore, Rs. 1500/40,000 1500/40,000 x100 = 3.75%
Definitions Stonier: The Marginal Efficiency of any asset shows what an entrepreneur
expects to be able to earn from acquiring one more asset ass et of that kind compared with what he has to pay to buy it Kurihara: M.E.C. is the ratio between the prospective yield of additional capital
goods and their supply price. pr ice.
Determinants of Marginal efficiency Capital Marginal efficiency of Capital is governed by the expected yield of a capital asset and its supply price. In technical term the s ame are called: I.Prospective yield: It is the aggregate net return expected from it during its
whole life. In order to determine prospective yield, annual return of the capital is worked out. Aggregate of annual return expected from a capital asset over its lifetime, is called total prospective yield. The remainder, after deducting cost of production from total revenue earned by the sale of output produced with the help of capital asset, is called prospective yield. With rise in prices, prospective yield increases and with the fall in prices, it decreases. Prices are likely to change in the be expressed in terms of the following equations: Py = Q1 + Q2 + Q3 + Q4 +«««+ Qn (Here Py= Prospective Yield; Q1, Q2, Q3, Q4 and Qn = net revenue received in the first, second, third, fourth and nth year)
II. Supply Price : The other factor influencing M.E.C. of a capital asset is its supply price. The supply price of a capital asset is the cost of producing a new asset of that kind, not the supply price of an existing asset. Hence, the supply price of a capital asset is also called Replacement Cost. It remains fixed in the short period.
Formula for Determining Marginal Efficiency of Capital Marginal efficiency of capital is determined by i) prospective yield and ii) supply price. It can be expressed in terms of an equation. A capital asset actually remains operative for more than one year. Hence, its total prospective yield is the aggregate
of annual prospective yields throughout its life-period. Prospective yield can be found out like compound interest from the principal amount, that is, supply price of capital asset and marginal efficiency of capital. Hence, in the first year,
Py1 = SP(1+m) Or SP = P y1/(1+m) (Here, Py = Prospective Yield; SP = Supply Price ; m = MEC) In the second year Py becomes the principal amount. Hence,
Py2 = Py2(1+m)
Because Py1 = SP(1+m), hence Py2 = SP(1+m)(1+m) = (1+m)2 rd
In the 3 year Py2 becomes the principal amount. Hence,
Py3 = Py2(1+m) Because Py2 = SP(1+m)2, hence Py3 = SP(1+m)2(1+m) = SP(1+m)3 Or SP = Py3/(1+m)3 Supposing, Life time of a capital asset is five years. In these five years, the aggregate of net return expected by the use of capital asset will be called Prospective Yield. In other words, the aggregate of expected net retur n of all the years over total life-time of a capital asset is called prospective yield. In µn¶ years, we can know the supply price of a capital asset.
DETERMINATION OF M.E.C. IN THE FORM OF RATE OF DISCOUNT
Rate of discount is that rate which equates future value of a capital asset with its present value. Lord Keynes has explained marginal efficiency of capital in terms of that discount rate which makes the prospective yields of a capital asset equal to its supply price. In the words of Keynes, ³I define the MEC as being equal to that rate of discount which would make present value of the series of annuities given by the return expected from the capital asset during its life just equal to its supply price.´ In simple words, in order to equate prospective yield of a capital asset with its supply price, marginal efficiency is deducted from it. Thus,
Supply Price = Discounted Prospective Yield It is further clarified with the help of the following equation:
SP = Py1/(1+m) + Py2/(1+m) + Py3/(1+m) +«««+ Pyn/(1+m) st
(Here SP = Supply Price; P y1, P y2, P yn = 1 year, 2
nd
year and nth year
prospective yield; m=Marginal Efficiency of Capital)
Marginal Efficiency of Capital can be known with the help of above equation. It has already been made clear that in dynamic society, annual prospective of a capital asset goes on changing every year. As a matter of fact, there is some rate of discount or marginal efficiency of capital that equates both sides of the equation. It is further illustrated by a example. Supposing, the supply price of a capital asset is Rs.1800. Total life-span of this capital asset is 2 years. Prospective yield of this capital asset in the
first year, is Rs.1050 and in the second year Rs.882. Thus, five percent is that rate of discount which will equate the aggregate prospective yield of the capital asset pertaining to both year with its supply price.
Rs. 1800 = Rs. 1050/(1+0.05) + Rs. 882/(1+0.05) In the above equation, 5% rate of discount equates total prospective yield of capital asset with its supply price. It will be called marginal efficiency of capital. According to Prof. Keiser, ³The marginal efficiency of capital is the rate at which the prospective yield from an asset must be discounted to bring it into quality with the supply price.´
Further Marginal efficiency of capital, Be determined by supply price (p) and expected rate of returns (annual returns) (Q). Marginal efficiency of capital, e= f (Q,P) There is a negative relationship between MEC and the volume of investment. This negative relationship is due to three reasons: 1. Keeping all other factors constant, when the volume of investment increases, law of diminishing returns operates and the productivity of increasing factor decrease. 2. When, the production increases, the product prices may decrease causing a decline in the rates of returns and marginal efficiency of capital. 3. When, the demand for other factors increases the factor prices may increase causing increase in cost of production and decrease in marginal efficiency of capital.
With increasing levels of investment, MEC can be kept constant. This is possible only by shifting the MEC curve. Shift in the MEC curve means a change in the production function and change in the level of technology.
FACTORS DETERMINING M.E.C. Marginal efficiency of capital depends on two sets of factors:
a. Short run factors, and b. Long run factors a. Short run factors Short run factors are important in determining marginal efficiency of capital as well as investment. Following are the long run factors affecting marginal efficiency of capital:
1. Marginal propensity of consumption Increasing level of marginal propensity of consumption increases marginal efficiency of capital. The intensity of consumption encourages marginal efficiency of capital.
2. Income Higher levels of income yield larger marginal efficiency of capital. Increasing income will also increase conspicuous consumption.
3. Price level During periods of inflation marginal efficiency of capital will be high. Price levels with more money supply will increase capacity to pay.
4. Interest rate Higher interest rates discourage marginal efficiency of capital. Higher cost of capital increases cost of production thus reducing chances of increasing marginal efficiency of capital
5. Consumption expenditure Higher consumption expenditure increases the marginal efficiency of capital. Increasing consumption expenditure can be due to reasons like income, price levels, demonstration effect or price illusion.
6. Government Policy Government policy of taxation, controls on output will reduce the possibility of increasing marginal efficiency of capital.
7. Business cycles Business cycles mainly deal with mood in business environment. There can be business optimism or business pessimism. During 17 periods of business optimism the marginal efficiency of capital will be high similarly, during periods of business pessimism, marginal efficiency of capital will be low.
8. Rational expectations A rational expectation is a post Keynesian concept, concerned with business environment and business. It is regarding the business adapting to changing policy, market, consumer expectation and management of business with rational risk management.
b. Long run factors Long run factors do not fall under the study of Keynes, because, Keynesian economics is short run economics. Yet, these are the factors
which are effective in the ling run. Following are the long run factors affecting marginal efficiency of capital:
1. Population Though population changes even in the short run. The effect of population can be seen only in the ling run, by way of changes in the pattern of demand and labor force.
2. Technology Technology helps in the ling run in reducing costs and making production function efficient.
3. Alternative sources of raw material and energy Alternative and cheaper sources of raw material and energy change the production function and help in expanding out put and making it economical.
4. Expanding markets Expanding markets provide purpose for the industry to produce and distribute. In the long run, mass consumption increase.
