Model Answer
0 min readIntroduction
In the realm of investment theory, John Maynard Keynes introduced the concept of the Marginal Efficiency of Capital (MEC) as a crucial determinant of investment levels. Alongside the prevailing rate of interest, MEC dictates the profitability of an investment project and, consequently, influences aggregate demand and economic activity. Understanding this relationship is fundamental to comprehending how investment decisions are made in a market economy. The interplay between these two forces determines whether an entrepreneur will find an investment worthwhile, thereby impacting capital formation and economic growth.
Defining Marginal Efficiency of Capital (MEC) and Rate of Interest
Marginal Efficiency of Capital (MEC) refers to the expected rate of return from investing an additional unit of capital. It’s essentially the discount rate at which the present value of the expected future stream of income from an investment equals its initial cost. It’s a subjective assessment based on business confidence and future expectations.
The rate of interest, on the other hand, represents the cost of borrowing capital. It is determined by monetary policy, supply and demand for loanable funds, and other macroeconomic factors. It’s an objective, market-determined price.
The Investment Decision Rule
Investment projects are undertaken when the MEC exceeds the rate of interest. This is because the expected return from the investment is greater than the cost of borrowing the funds. Conversely, if the rate of interest is higher than the MEC, the project is deemed unprofitable and will not be pursued.
- MEC > Rate of Interest: Investment is profitable and will occur. Businesses will borrow and invest, leading to economic expansion.
- MEC = Rate of Interest: Investment is at a breakeven point. Investment decisions are marginal and depend on other factors.
- MEC < Rate of Interest: Investment is unprofitable and will not occur. Businesses will refrain from borrowing and investing, potentially leading to economic contraction.
Illustrative Example
Consider a firm evaluating a new factory. The factory is expected to generate a net present value (NPV) of ₹100 crore over its lifetime. The initial cost of the factory is ₹80 crore. The MEC is calculated as (₹100 crore / ₹80 crore) = 1.25 or 25%. If the prevailing rate of interest is 20%, the firm will invest in the factory because the MEC (25%) is higher than the rate of interest (20%).
Factors Influencing MEC
Several factors can influence the MEC, making it a dynamic variable:
- Business Confidence: Optimistic expectations about future demand and profitability increase MEC.
- Technological Advancements: New technologies can create opportunities for higher returns, raising MEC.
- Government Policies: Tax incentives, subsidies, and infrastructure development can positively impact MEC.
- Demand Conditions: Strong demand for goods and services increases the profitability of investments, boosting MEC.
Limitations and Complexities
While the MEC-interest rate relationship is a powerful analytical tool, it’s important to acknowledge its limitations. MEC is a subjective estimate, prone to errors and biases. Furthermore, liquidity preference, expectations about future interest rates, and the availability of credit can also influence investment decisions, independent of the MEC-interest rate comparison. The time lag between investment decisions and actual returns also introduces uncertainty.
Conclusion
The marginal efficiency of capital, in conjunction with the current rate of interest, provides a fundamental framework for understanding investment decisions. When MEC surpasses the rate of interest, investment is incentivized, driving economic growth. However, the subjective nature of MEC and the influence of other macroeconomic factors necessitate a holistic approach to investment analysis. Policymakers can leverage this understanding to create an environment conducive to investment through appropriate monetary and fiscal policies.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.