MEC Curves                                 

The marginal efficiency of capital curve in Figure 4.4 shows possible levels of investment (on X –axis) corresponding to various of the MEC (on Y-axis). The downward slope of the MEC curve indicates the negative relationship between the level of investment and the MEC. As the level of investment rises from I0 to I1, the MEC falls from i0 to 1i . Thus, with the increase in the level of investment the marginal efficiency of capital falls and vice – versa.

There are two reasons for the inverse relationship between the investment and the marginal efficiency of the capital. First, increase in the investment on one hand reduces the marginal productivity of the capital asset due to operation of the diminishing returns. On the other hand, in decreases the price of the goods  due to increase in production. Hence, the prospective returns fall. Secondly, the supply price of the asset will increase due to its rising demand, as the stock of the real capital increases.
                                          
The marginal efficiency of capital curve may shift with change in the expectations of the investors. An optimistic attitude of the businessmen regarding the prospective returns from the capital asset would shift the MEC curve upwards. Such a shift in the MEC curve is shown in the Figure 4.5. We note that for the same value of the marginal efficiency of capital, more investment (OI2) is forthcoming on MEC curve due to the prevalence of business optimism. For example, a reduction in the corporate tax or income tax will motivate entrepreneurs to revise upwards their investment plans. Similarly, the improvements in the technology will be favourably taken by the investors. On the contrary, if pessimism prevails, the prospective returns on capital would fall to a very low level and MEC curve will shift downwards. For example, wage cuts resulting in a decline in income and consequent fall in the demand for the goods and the services, will push down the MEC curve. Further, higher direct taxes may also reduce the investment demand. Thus, we observe that the MEC on which the investment demand depend is influenced by the government policy, technological factors, business conditions.etc, which are quite unpredictable.