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Factors on Which Marginal Efficiency of Capital Depends:

(1) Marginal Efficiency of Capital (MEC).

(2) Market Rate of Interest.

 

The producer's decision as to whether or not, he should undertake a given investment project is arrived at by comparing marginal efficiency of capital (MEC) with the market rate of interest (or the cost of funds).

 

Meaning of Marginal Efficiency of Capital:

The marginal efficiency of capital is the expected annual rate of return on an additional unit of a capital good. It is also described as the rate of return expected to be received on money if it were invested in a newly produced asset. According to J.M. Keynes:

"The marginal efficiency of capital is the rate of discount which makes the present value of the prospective yield from the capital asset equal to its supply price. The marginal efficiency of capital will progressively diminish as investment in the asset increases. The marginal efficiency of capital (MEC) curve is, therefore negatively sloped".

Factors Affecting MEC:

The marginal efficiency of capital is influenced by short run as well as long run factors. These factors are now discussed in brief:

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Short Run Factors:

(i) Demand for the product. It the market for a particular good is expected to grow and its costs are likely to fall, the rate of return from investment will be high. If entrepreneurs expect a fall in demand of goods and a rise in cost, the will decline.

(ii) Liquid assets. If the entrepreneurs are holding large volume of working capital, they can take advantage of the investment opportunities that come in their way. The MEC will be high and vice versa.

(iii) Sudden changes in income. The MEC is also influenced by sudden changes in income of the entrepreneurs. If the business community gets windfall profits, or there are tax concession etc., the MEC will be high and hence investment in the country will go up. On the other hand, MEC falls with the decrease in income.

(iv) Current rate of investment. Another factor which influences MEC is the current date of investment in a particular industry. If in a particular industry, much investment has already taken place and the rate of investment currently going on in that industry is also very large, then the marginal efficiency of capital will be low.

(v) Wave of optimism and pessimism. The marginal efficiency of capital is also affected by waves of optimism and pessimism in the business circle. If businessmen are optimistic about future, the MEC will be overestimated. During periods of pessimism the MEC is under estimated.

 

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Long Run Factors:

The long run factors which influence the marginal efficiency capital are as under:

(i) Rate of growth of population. Marginal efficiency of capital is also influenced by the rate of growth of population. If population is growing at a rapid speed, it is usually believed that at the demand of various classes of goods will increase. So a rapid rise in the growth of population will increase the marginal efficiency of capital and  a slowing down in its rate of growth will discourage investment and thus reduce marginal efficiency of capital.

(ii) Technological development. If investment and  technological development take place in the industry, the prospects of increase in the net yield brightens up. For example, the development of automobiles in the 20th century has greatly stimulated the rubber industry, the steel and oil industry, etc. So we can say that inventions and technological improvements encourage investment in various projects and increase marginal efficiency of capital.

(iii) The quantity of capital goods of relevant types already in existence. If the quantity of any particular of goods is available in abundance in the market and the consumers can partially or full meet the demand, then it will not be advantageous to invest money in that particular project. So in such cases, the marginal efficiency of capital will be low.

(iv) Rate of taxes. Marginal efficiency of capital is directly influenced by the rate of taxes levied by the government on various commodities, When taxes are levied, the cost of commodities is increased and the revenue is lowered.

When profits are reduced, marginal efficiency of capital will naturally be affected. It will be low.

The document Factors affecting MEC - Macro Economic Framework, Macroeconomics | Macro Economics - B Com is a part of the B Com Course Macro Economics.
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FAQs on Factors affecting MEC - Macro Economic Framework, Macroeconomics - Macro Economics - B Com

1. What is the macroeconomic framework and how does it affect the Marginal Efficiency of Capital (MEC)?
Ans. The macroeconomic framework refers to the overall structure and policies of an economy, including fiscal and monetary policies. It plays a crucial role in shaping the Marginal Efficiency of Capital (MEC). When the macroeconomic framework is supportive, with favorable policies such as lower taxes, adequate infrastructure, and stable interest rates, it can enhance the MEC by encouraging investment and economic growth. Conversely, an unfavorable macroeconomic framework can hinder the MEC by discouraging investment and economic activity.
2. How does the macroeconomic framework impact the MEC in terms of fiscal policies?
Ans. Fiscal policies, such as government spending and taxation, are an important component of the macroeconomic framework. When fiscal policies are expansionary, with increased government spending and lower taxes, it can lead to a higher MEC. This is because expansionary fiscal policies stimulate aggregate demand and create a favorable investment climate. On the other hand, contractionary fiscal policies, with reduced government spending and higher taxes, can dampen the MEC by reducing consumer and business spending.
3. What role does the macroeconomic framework play in influencing the MEC through monetary policies?
Ans. Monetary policies, controlled by the central bank, are another vital aspect of the macroeconomic framework. When monetary policies are accommodative, with lower interest rates and easy access to credit, it can boost the MEC. This is because lower borrowing costs encourage businesses to invest in new projects and expand their operations. Conversely, restrictive monetary policies, with higher interest rates and tighter credit conditions, can lower the MEC by making borrowing more expensive and reducing investment incentives.
4. How does the macroeconomic framework affect the MEC through infrastructure development?
Ans. Infrastructure development is a key component of the macroeconomic framework that can significantly impact the MEC. When an economy has well-developed infrastructure, such as reliable transportation networks, efficient communication systems, and modern utilities, it can enhance the MEC. This is because adequate infrastructure reduces production costs, improves logistical efficiency, and creates a conducive environment for businesses to operate and invest. In contrast, a lack of infrastructure can hamper the MEC by increasing costs and hindering economic growth.
5. How does the stability of the macroeconomic framework influence the MEC?
Ans. The stability of the macroeconomic framework is crucial for the MEC. When an economy experiences macroeconomic stability, characterized by low inflation, stable exchange rates, and consistent economic policies, it can positively impact the MEC. This stability provides businesses with certainty and confidence in their investment decisions, as they can plan for the future without significant disruptions or uncertainties. In contrast, an unstable macroeconomic framework, marked by high inflation, volatile exchange rates, and inconsistent policies, can lower the MEC by increasing risks and reducing investor confidence.
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