Marginal efficiency of capital and rate of interest influence the investment decisions

Analysis of the role of marginal efficiency of capital and market rate of interest in investment decision or,
Marginal efficiency of capital and rate of interest influence the investment decisions

The marginal efficiency of capital along with rate of interest determines the amount of new investment, which in turn, determines the volume of employment, given the propensity to consume. In the fundamental equation Y = C + I, given by Keynes, we have seen that income at a time deposits upon consumption and investment, consumption being stable in the short-run and less than unity a gap comes to exist which can be wiped off only by an increase in investment. Investment is an essential requirement for full employment and the key to prosperity in a capitalistic economy.

Marginal efficiency of capital refers to the anticipated rate of profitability of a new capital asset. It is the expected rate of return over cost from the employment of an additional unit of capital asset. Marginal efficiency of capital depends upon the expected rates of return of a capital asset over its lifetime and the supply price of the capital asset.

Marginal efficiency of capital (MEC) and the rate of interest are the two important factors, which affect the volume of investment, and these two must be determined beforehand independently of each other. MEC is the result of the supply price and the prospective yield of the capital asset. Rate of interest is the price paid for loanable funds and is determined, like any other price, by the demand for and supply of loanable funds. A potential investor will go on weighing the MEC on new investment against the rate of interest. As long as MEC is more than the rate of interest investment will continue to be made, till the MEC and the rate of interest are equalized. Once the MEC becomes equated to the rate of interest, equilibrium investment is determined. Thereafter investment has to be increased, either the rate of interest should fall or MEC should increase.

It is true that both MEC and the rate of interest are important determinants of investment. The rate of interest is very important in the effective implementation of fiscal policy. But as a means of increasing private investment it could be of importance, if the marginal efficiency of capital were highly elastic. In the Keynesian general theory, attributed fluctuations to the changes in expectations and shifts in the MEC and not to the rate of interest. The relation of the MEC and the rate of interest as determinants of the amount of investment and hence of employment.

The following table depicts clearly the relationship of MEC and the rate of interest in the determination of the inducement to invest,
Supply PriceAnnual ReturnMECRate of InterestEffect on Investment
Rs. 25.00Rs. 1.004%4%Neutral
Rs. 20.00Rs. 1.005%4%Favorable
Rs. 25.00Rs. 1.003%4%Adverse
In this table, it is assumed that the new capital asset in question gives constant return of Rs. 1,000 annually. The MEC and the rate of interest are given separate columns, having been determined independently of each other. When MEC (4%), is equal to the rate of interest (4%), the effect on investments is natural; when it is more, the effect is favorable and when MEC is less than the rate of interest, the effect on induced investment is unfavorable.

The position and shape of the investment demand schedule pay a decision role in determining the volume of investment because it shows the extent to which the amount investment changes as a result of changes in the rate of interest. If the demand (MEC) schedule is relatively interest-elastic, a little fall in the rate of interest will lead to a considerable increase in investment.

In the figure (A), below shows an interest-elastic investment demand schedule. When the rate of interest falls from 6% to 4% investment increases from OI to OI’. In figure (B) shows an interest-inelastic investment demand curve. Corresponding to the same fall in the rate of interest from 6% to 4%. Increase in investment II’ is much less.

There has been a lot of controversy on the expansion of interest elasticity of the investment demand schedule. Experience confirms the views that it tends to be interest inelastic especially during depression.

A change in the MEC or in the rate of interest or both induces a change in the level of investment, as shown fig (C). We find that a rise in the MEC is accompanied by a constant rate of interest 4% resulting an increase in the level of investment. Figure (D) further describes the case of a rise in the rate of interest from 4% to 5% with no change in the MEC schedule and the level of investment falls from OI to OI’.

Evaluation of Investment Project by Benefit-cost Ratio Method

The benefit-cost ratio is the most popular method of project evaluation. It is the ratio of present value of the stream of net cash flows of a project over its life span to the initial cost of the project.

Under this criterion, a project will be accepted if and only if BCR is no less than unity. Thus, both the projects are greater than one. It helps the planning authority for making appropriate investment decisions to achieve optimum measure of allocation of resources by maximizing the difference between present value of benefit and costs of a project. There are various criteria for cost benefit analysis.

(i) B – C, (ii) B – C/I, (iii) ∆B/∆C and (iv) B/C

Where, B refers benefits, C refers costs; I refers direct investment and ∆ refers small change.

B – C shows the difference between benefits (B) and costs (C). This criterion determines the scale of project on the basis of maximizing the difference B and C. The formula, B – C/I shows the total annual returns on a particular investment to the economy as a whole. If the private investment is large, then even high value of B – C/I may be less beneficial to the economy.

The criterion of ∆B/∆C is the more appropriate than others. ∆B/∆C = 1 indicates the size of project. The best and effective criterion for the project evaluation is B/C. Under this criterion, the evaluation of project is done on the basis of benefit cost ratio. If the value of B/C = 1, the project is marginal because the benefits occurring from the project just cover the costs. If the value of B/C < 1, it shows the benefits are less than costs and the project is deficit, thus the project is rejected. If the value of B/C > 1, it shows the benefits are more than costs and project is profitable, thus it is selected.

In the criteria, which, we discussed above, does not account for the time factor. The future benefits and costs cannot be treated at par with present benefit and cost. Hence, project evaluation requires discounting of future benefits and costs because prefers present for the future.

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