MEC AND RATE OF INTEREST

The marginal efficiency of a particular capital asset can be calculated by relating the prospective yields from the asset with its supply price. The marginal efficiency of an asset shows what an entrepreneur expects to earn from one more asset of that kind as compared to what he has to pay for it. It is the internal rate of return on that asset. Since the calculation of MEC depends upon the estimates of future, if is a highly subjective and uncertain quantity. It pays to invest in general so long as this expected rate of return from the capital asset exceeds the market rate of interest. This is explained below.

When an entrepreneur decided to invest in a capital good, he either borrows funds from the market or uses his own resources to finance the investment project. In the former case, he has to pay the market rate of interest, while in the latter case, he sacrifices the interest which he could have got by lending out these funds. In any case, interest is the price of investment. The entrepreneur compare this price of investment with the income (or profit) he expects from the investment in the form of the expected rate of return or the marginal efficiency of capital. If the MEC (i) is greater than the market rate of interest (r), it is worthwhile to undertake the project, even if the entrepreneur has to borrow all or part of the required funds at the market rate of interest. On the other hand, if the MEC is less than the market rate of interest, the investment project is not profitable. In this situation, the entrepreneur should rather lend the available funds at the market of interest. For example, if MEC is 10% and the current market rate of  interest is 8%, the investment promises a net return of 2%, after making provision for all costs including the interest cost on the funds and the depreciation cost of the asset. If, however, the interest rate rises to 12%, the prospective investor should not undertake the project, since the net rate of return is -2%. Thus, the net return is the difference between marginal efficiency of capital and the market rate of interest.

It is important to observe that the estimate of MEC for any capital asset in no way depends upon the market rate of interest. Once MEC is estimated, the market rate of interest simply tells us whether the proposed investment project is profitable or not, by comparing with its MEC. A change in the market rate of interest (r) will not affect the MEC. But, if r<MEC before the rise of interest rate and r>MEC after the rise, the investment project which previously appeared to be profitable, will now become unprofitable. Thus, rise in the market rate of interest decreases the expected profitability of the capital good or even turning it into expected loss and vice-versa.