John Maynard Keynes,The General Theory (BN Publishing, 2008), pp. 135–146.

The Marginal efficiency of capital

I.

A man buys capital-assets, also buying the right to the returns yielded from selling its output: the prospective yield. We also have the supply price, which is the minimum return an entrepreneur requires to induce him to invest (also called a replacement cost). The relationship between these two variables is the marginal efficiency of capital; that is, where income earned from the use of capital is equal to its supply price. These terms are all forward looking, in the sense that they are values based on entrepreneurial expectations.

Typically, the rate of investment will be set at the point where the marginal efficiency of capital is equal to the rate of interest. Therefore, the inducement to invest relies both on the investment demand-schedule and the rate of interest — this supposedly becomes clearer as we push through Book IV (the next one hundred pages).

II.

Let’s compare Keynes’ “marginal efficiency of capital” (MEC) to other familiar terms with similar meanings, such as “marginal productivity” or “yield.” In defining these terms, Keynes notes that there exist “three ambiguities,”

What matters? The increase in physical output per unit of time that the marginal unit of capital brings about? Or, the increase in value as a result of the employment of the marginal value unit of capital? Keynes seems to favor the second choice, given that defining capital and output in real terms is difficult, and he can’t reduce the relationship by means of arithmetic; Is the MEC an absolute quantity or a ratio; Should we consider the increment discussed in (1) related only to one point in time — as in a static model —, or should we consider the MEC of the marginal unit over its entire productive life (necessarily bringing in expectations)?

In a couple of brief paragraphs Keynes discusses the relationship between the marginal efficiency of capital and the rate of interest. The MEC doesn’t decide the rate of interest; rather, the rate of interest decides the volume of investment, given the MEC. In other words, if the rate of interest is 3%, entrepreneurs won’t invest unless they expect an increase in output of at least 3%. Keynes also notes that the MEC is mostly analogous with Irving Fisher’s term “the rate of return over cost,” where this latter term implies that an investment won’t take place unless the rate of return over cost is greater than the rate of interest.

III.

Keynes again emphasizes the importance of prospective yields; i.e. the expectations of profits. That is, today’s marginal efficiency of capital has as much to do with how much the entrepreneur expects to get in return from its use tomorrow as much as today. The expectation of all in the MEC of a particular unit of capital will decrease its value today. Keynes has a paragraph on changes in the value of money, suggesting that an expectation in the fall in the value of money will increase MEC — this isn’t necessarily true (the rise in the value of money could be caused by an increase in output). This leads to a discussion of Irving Fisher’s theory of real and nominal interest rates. Keynes notes that what changes in money value do is change the MEC, not the rate of interest.

Also, an expectation of a fall in the rate of interest might depress the present MEC, given that entrepreneurs might further expect to have to compete with new production willingly made at a lower return. In other words, this kind of expectation might lead to an expectation of a fall in the value of output. This may be partially offset, though, by a present reflection of this expectation (in the present rates of interest). Keynes notes that understanding the impact of expectations on the marginal efficiency of capital is important to understand how “violent fluctuations” in expectations explain industrial fluctuations.

IV.

There are two (potentially three) types of risk that affect the volume of investment,

The entrepreneur’s risk associated with the probability of actually achieving the prospective yield; In the world of financial intermediation, there also exists “lenders’ risk:” the probability of default; Unexpected change in the value of money.

V.

Keynes again emphasizes the principal take away from the chapter: the marginal efficiency of capital depends heavily on expectations — more so than any other factor, including the rate of interest. In passing, largely to justify his continued re-statement of the just mentioned point, he also notes that durable capital equipment is the influence of today on tomorrow (a point that Hayek uses, largely against Keynes, in “Investment That Raises the Demand for Capital”).