MARGINAL EFFICIENCY OF CAPITAL

(DETERMINANTS OF INVESTMENT)

According to Keynes, the decision to invest in a new project (i.e., private investment) depends upon the marginal efficiency of capital and the market rate of interest. The marginal efficiency of the capital is, in turn, determined by the supply price of the capital asset and prospective yields from the capital asset.

SUPPLY PRICE OF CAPITAL ASSET

 When an entrepreneur wishes to buy a capital asset, he will have to pay the price for the same. This amount is called the purchase price of the capital asset. Keynes has termed this cost of acquisition of the asset as the supply price or the replacement cost of the capital asset. It is the price at which the new capital asset is supplied or replaced. It is possible that the supply price of the asset may spread over a number of years, particularly in the case of services like constructions, etc. As a consequence, full cost to the entrepreneur may turn out to be substantially different from the expected amount. However, to simplify in the present analysis, such situation is not considered.

PROSPECTIVE YIELDS FROM CAPITAL ASSET

The prospective yields or the expected income flows from capital asset are the expected revenues from the sale of output produced by the asset during its life time minus variable costs. The variable or the running costs are the expenses incurred on raw materials, wages, advertising, maintenance, transportation, etc. The marginal efficiency of capital depends upon changes in the long term expectations of entrepreneurs regarding prospective yields of capital assets. Thus, expectations with regard to profit or loss encourage or discourage inducement to invest in these two cases respectively. When entrepreneurs are optimistic or pessimistic regarding future expectations, the marginal efficiency of capital rises or falls and brings changes in the volume of investment at different rates of interest.

Every entrepreneur who decides to build a new factory or buy a new machine, first considers the prospective yields of the asset. All the capital assets last long and the yields on them are usually spread over several years in future. A forecast of what lies in the future is inevitable. The uncertainty arises not only as to the returns, but also the life of the capital good. The uncertainty in future returns arises due to uncertainty in the productivity of the capital asset and the price of the product in the future. Even if the physical life of the asset is known, it is difficult to know its economic life due to the possibility of the technological changes. As a result, a good may become obsolete before it is physically worn out. Thus, the entrepreneur has to estimate carefully the life of the capital asset as well as the flows of income during its life time.

It is clear from the above discussion that the supply price is the current cost of the assets, while the prospective yields are future returns from the asset. The yields spread over the economic life of the capital asset should be made comparable to its supply price, since the future yields are worth less than the equivalent amount now. The entrepreneur cannot know the time difference between the future yields and present lump sum expenditure on the new investment.

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