Marginal Efficiency of Capital (MEC)

MEC refers to the expected profitability of a capital asset. It may be defined as the highest rate of return over cost expected from the marginal or additional unit of a capital asset. First, we must go to the marginal unit of the capital asset and secondly, its cost has to be deducted from its return. Now the MEC, in its turn, depends on two factors: the prospective yield of the capital asset and the supply price of the capital asset. The MEC is the ratio of these two factors. The prospective yield of a capital asset is the total net return from the asset over its lifetime. 

 Supply price or Initial investment.

 Prospective yields or cash inflows at t period.

 Marginal Efficiency of Capital.

The MEC is the net rate of return that is expected from the purchase of additional capital. It is calculated as the profit that a firm is expected to earn considering the cost of inputs and capital depreciation. It is influenced by expectations about future input costs and demand. The MEC and capital outlay are the elements that a firm considers when deciding about an investment project.

John Maynard Keynes advocates the rate of return approach to economic calculation. In the rate of return approach, investors use the marginal efficiency of capital (MEC) to rank investment projects. Keynes defines the marginal efficiency of capital as the “rate of discount which would make the present of the series of annuities given by the returns expected from the capital asset during its life just equal to its supply price”. In other words, the marginal efficiency of capital is the discount rate which makes the NPV equal to zero. 

In the Keynesian rate of return, framework investment decisions are made by comparing the marginal efficiency of capital to the interest rate. Thus, the MEC rule is to accept an investment project if the marginal efficiency of capital is greater than the interest rate. Put differently, the MEC rule is to accept an investment project if the rate of return is greater than the cost of capital. Conversely, The MEC rule is to reject an investment project if the marginal efficiency of capital is less than the interest rate.

Numerical Example:

Consider the case of a wooden bridge costing $2,000 whose life is only three years and which offers the prospect of a series of yields of $1,000 in each of three years” The wooden bridge will generate cash flows of 1,000 per year for three years. If the interest rate is 10%, then the present value (PV) of the wooden bridge is 2,486.85.

The net present value equals the present value minus the price of the investment. Thus, in Hansen’s example, the net present value of the wooden bridge is the present value of 2,486.85 minus the price of 2,000. 

The present value of the wooden bridge is 2,486.85, while the price of the wooden bridge is only 2,000. Therefore, the net present value is 486.85.

There is an important negative relationship between the interest rate and the present value of an investment project.  All else equal, the present value of an investment project increases as the interest rate falls. In Hansen’s example, suppose the interest rate is 5% instead of 10%. In this case, the expected cash flows are discounted by 5%. Since the expected cash flows are discounted at a lower rate, the present value increases from 2,486.85 to 2,723.25.

Marginal Efficiency of Capital
Time	Cash Flow	Discounted Cash Flow
0	-2,000	-2,000
1	1,000	810.54
2	1,000	656.97
3	1,000	532.50
Present Value		2,000
Net Present Value		0
MEC		23.38%

The marginal efficiency of capital of the wooden bridge is 23.38%. Therefore, when the expected cash flows from the wooden bridge are discounted at 23.38%, the present value equals the 2,000 supply price of the bridge. Put differently, the net present value is zero when the project expected cash flows are discounted at 23.38%. This can be seen using the NPV schedule. The table above shows that the net present value declines as the interest rate rises and finally equals zero when the interest rate is 23.38%.

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