Page 94 - DECO402_Macro Economics

Unit-10: Investment Function

10.3 MEC and Rate of Interest Notes

The Marginal Efficiency of Capital of a special capital asset can be known on relating the expected
receipts of asset with its supply price. The Marginal Efficiency of Capital of an asset shows what
the entrepreneur expects to acquire in comparison to the payment from an extra asset of that type.
It is the internal rate of return on that asset. Because the estimation MEC is dependent on the future
forecasting, this is a very subjective and indefinite quantity. Generally profit becomes from investing,
until this relative rate of return from capital asset is more than the market rate of interest. It is described
following.
When an entrepreneur decides to invest in any capital good, he either borrow fund from the market,
or arranges the finance on using his own sources for investment plan. In first condition, he has to
pay the interest rate of market while in second condition he rejects that interest, which he could get
on lending these funds. In any of the condition, interest is the price of investment. Entrepreneur
compares this price of investment with the income (or profit) from investment in the form of relative
rate of return or with Marginal Efficiency of Capital. If the Marginal Efficiency of Capital (i) is less than
market rate of interest (r), to start the plan is beneficial, though entrepreneur had to borrow on market
rate of interest of fully or partially important funds. On the other side, if the Marginal Efficiency of
Capital is less than market rate of interest, then the investment plan is not beneficial. In this situation,
entrepreneur should lend the available funds on market rate of interest. For example, if the Marginal
Efficiency of Capital (MEC) is 10% and market rate of current interest is 8%, then on provisioning of
all costs as the interest cost of funds and the depreciation cost of asset, investment gives the net return
of 2%. But, if interest rate becomes 12% then prospective investor should not start the plan because
the net rate of return is -2%. Therefore, the net return is the difference between Marginal Efficiency
of Capital and market rate of interest.
It is very must to see that the Marginal Efficiency of Capital (MEC) doesn’t depend on market rate
of interest anyhow for any capital asset. Once on estimating the Marginal Efficiency of Capital, the
market rate of interest only shows is the proposed investment plan beneficial, when the Marginal
Efficiency of Capital is compared with this rate. There would be no effect on Marginal Efficiency of
Capital (MEC) from the change in rate of interest (r). But, if before the rise in the rate of interest, it
becomes lower than Marginal Efficiency of Capital and rate of interest becomes more than Marginal
Efficiency of Capital after increasing, which investment plan was seemed as beneficial previously,
now seemed as unbeneficial. Therefore, the rise in the market rate of interest reduces the relative
profitability of capital goods and till here changes it in the relative loss and vice-versa.

MEC Schedule

On a definite time, a firm has to face the different kinds of investment opportunities. Some of these for
the change in investment technique, while other become necessary for the expansion in production
units. The decision to put the investment expenditure for each possible plan is done on the basis of
the Marginal Efficiency of their Capital and market rate of interest. Firm will select those investment
plans, for which the Marginal Efficiency of Capital (MEC) is more than the market rate of interest
(r). Firm is expected to select the different plans in the decreasing order of its Marginal Efficiency of
Capital, because firms are aimed to make the return maximum. So, according to availability of funds
and market rate of interest, the Marginal Efficiency of Capital list is made on classifying the investment
opportunities in the decreasing order of its Marginal Efficiency of Capital. It can be understood with
the help of following Marginal Efficiency of Capital list, where 5 plans which a firm starts, are classified
in the decreasing order of its Marginal Efficiency of Capital. (Table 4.1)
We see that the list of marginal efficiency of capital shows the relation of alternative levels of MEC
investment of personal firms. If market rate of interest is 13%, then first project of 5 crores is profitable.

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