Marginal Efficiency of Capital (MEC)

Read this article to learn about the Marginal Efficiency of Capital (MEC) at business expectations.

The marginal efficiency of capital, at any time, depends upon the state of entrepreneurs’ expectations. It is raised by invention and innovation and by the expectation of rising prices.

It is lowered by any general threat to reduce the yield of capital goods while at the same time their supply price is likely to be increased.

It is also affected by the state of entrepreneurs’ animal spirits; for much investment is made not merely as a result of calculation but under the stimulus of irrational optimism.

It is always subject to violent fluctuations, owing to fundamental uncertainty of the world in which we live. We have little means of knowing exactly the value or yield of capital in future. So we take the present as guide to future. We accept existing opinion, the community judgment, and the behaviour of the majority as a correct indicator of prospects, and though this is good enough as long as stability reigns, it exposes us lo sudden and violent changes when our expectations turn out to be unjustified.

Thus, Keynes’ Theory of the marginal efficiency of capital is based on the strategic role of business expectations. Business expectations play a significant part in the theory of employment, because businessmen can never be quite sure in respect of the prospective yield of any capital asset or investment. Out of the two determinants (supply price and prospective yield) of the marginal efficiency of capital, it is the prospective yield which gives its most important characteristic instability.

Keynes maintained that the considerations on which expectations of prospective yield base are partly the existing events (which can be more or less ascertained) and partly future facts (which cannot be anticipated with confidence). It is essentially due to uncertain events on which the prospective yields mainly depend that the marginal efficiency of capital is so unstable. Hence, a large part of the instability of economic behaviour under capitalism is ascribed to the unstable character of prospective yield from capital assets.

The investment decisions are governed by expectations of yield and not by actual yields. For the purchase of durable capital assets requires huge immediate expenditures before any actual returns begin to flow back to the entrepreneur. Capital assets are, thus, a link between the present and the uncertain future. It is, therefore, essential to analyze the true nature of business expectations and their influences on the MEC.

These expectations are mainly of two types:

(i) Short-term expectations,

(ii) Long-term expectations.

Short-term expectations are based on the sales proceeds from the output of existing plant, these expectations are concerned with the existing facts. Under such circumstances the plant is presumed to be of fixed size, only the output from it is variable. Long-term expectations are the expectations of the entrepreneur based on future events and concern the sales proceeds from the variations in the size of plant or from the installation of an entirely new plant.

In the long-term expectations, the size of the plant as well as the amount of output from it is variable. The difference between two types of expectations is that in the short-run, it is very difficult to change the size of the plant, whereas in the long-run not only the size of the plant is changed but also new machinery can be installed.

(i) Short-Term Expectations:

According to D. Dillard, “short-term expectations are more stable than long-term expectations, because the realized results of the recent past are relatively a safe guide to what will happen in the near future, whereas there exists no past experience which will serve as a safe guide to what will happen in the distant future.” Moreover, in case of short-term expectations there is a high degree of continuity as most of conditions which affect current output remain more or less the same from day to day or from week to week or from month to month.

In the absence of a positive evidence necessitating a change, recent events may be expected to continue in the near future. Short-term expectations, by their very nature, can be checked in the light of realized result, and become a guide for ascertaining expectations relating to the near future. Since short-term expectations are stable, they are unable to explain fluctuations in investment. Therefore, in case of short-term plans it may be safe to rely on past results.

(ii) Long-Term Expectations:

The nature- of long-term expectations is quite different from the nature of short-term expectations. Long-term expectations concerning future yields are highly unstable and are, therefore, more important in explaining the fluctuations in total investment and the level of employment in the economic system.

While it may be safe to assume that economic activity next day or next week or even next month will be more or less the same as it was during the previous day or past week or past month, experience warns us against assuming that the next three or seven years will be like the past three or seven years, because the realized results of the past are not a dependable guide for the future.

Moreover, while ascertaining long-term expectations, many difficulties of a complex nature, like the probable life of the plant, maintenance and depreciation charges, future change in technology, level of effective demand, nature of new competition, possibility of war, shifts in tax burden, size of the export market, conditions of labour market, political climate of future years etc. crop up.

These are the considerations which are less predictable and make any scientific judgment regarding future highly precarious. Further, they make long-term expectations in respect of prospective yield highly unstable and account for the utter lack of confidence even in the most dependable forecasts, subjecting investment decisions to sudden shifts.

There are, however, some factors affecting long-term expectations which do not depend upon the uncertain future, as the decisions to invest are to some extent based upon facts regarding the existing stock of capital assets. For example, a decision to build a new sugar factory depends partly upon the amount of existing sugar output, a fact which can be easily ascertained, but as we try to project in the distant future and try to form long-term expectations, all the above-mentioned factors render such a forecast difficult. The distant future is never clearly foreseen specially when decisions are made by a large number of private businessmen.

Hence the nature of long-term expectations becomes highly uncertain, unstable and precarious. As Keynes observes, “The outstanding fact is the extreme precariousness of the basis of knowledge of the factors which will govern the yield in which decisions to invest have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years or even five years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing. In fact, those who seriously attempt to make any such estimate are often so much in the minority that their behaviour does not govern the market.”

Stock Exchanges and Prospective Yields:

The uncertain, unstable and the precarious nature of long-term expectations, which cause fluctuations in investment, is reflected in the activities of the stock exchange market in modern capitalist economies. When prospective yields are viewed favourably, stock prices tend to rise; and when these are viewed unfavourably, stock prices tend to fall. It may, however, be noted that the purchase or sale of securities does not represent real investment, but only a financial transaction. When one man invests (purchases) another man disinvests (sells).

Thus, the sale is equal to the purchase and the disinvestment is equal to the investment. Hence, total social investment, as well as total financial investment remains unaffected as a result of stock exchange transactions. What actually constitutes real investment is the employment of additional men and materials to build new factories and other types of capital assets. Although the transactions on the stock exchanges are primarily financial transactions and relate to sale and purchase of old stock, yet they affect real investment by affecting the prices of new stocks, shares and securities. Ability to float new securities at high prices tends to encourage investment in new projects on a large scale. High quotations for existing stocks imply that the MEC for this type of enterprise is high in relation to the rate of interest and, therefore, the inducement to invest is strong. It will be profitable to build new capital assets of the same type.

On the other hand, when the prices of old stocks on the stock exchange are low, it will be more profitable to purchase claim on the existing assets than to build new ones; because in these circumstances, the MEC of capital is likely to be lower than the current rate of interest and, therefore, there may be no inducement to invest. We find the real investment is governed by quotations of prices of securities on the stock exchanges.

These stock exchange markets, thus, become links between the present and the future, because it is in these markets that the existing investments are valued and revalued daily or even hourly. The main reasons for changes in values are changes in current expectations regarding future events. Any event that is likely to happen in future is taken into account (discounted) in the present prices of securities.

Speculation and Enterprise:

There is a considerable degree of speculation in the stock exchange which causes the instability of marginal efficiency of capital. Speculation consists in the attempt to anticipate the psychology of the market. Enterprise consists in an attempt to anticipate the yield of assets over their life time. In other words, a speculator has a tendency to ‘get rich quick’ by taking advantage of the fluctuation in prices of securities in the stock exchange market.

Therefore, he is not primarily interested in real investment but in the difference of prices as a result of speculative financial transactions to get rich overnight ; whereas an enterprise is interested in real investment in new capital assets by affording more employment to men and materials. He is, therefore, interested in forecasting the returns from the capital assets over their life time in the long-run. Keynes felt that the long-term expectations which govern the quotations of securities in the stock exchange are more the result of speculation than of enterprise.

Thus, speculation rather than the enterprise causes changes in the stock market price. The reason is that people generally have no idea of future events and no confidence in their individual judgments they tend to rely upon the judgment of others, who, they think, are better informed. This is, specially, true of amateur investors who do not possess the technical psychological, institutional and business knowledge which is used by professionals.

Their main concern is to depend upon ‘conventional judgment’ (i.e., acceptance of the unique correctness of the existing estimates of the future). That is why even the most skilled and experienced forecaster tries to forecast the market psychology, to rationalize the irrational activities of a large number of less skilled participants in the market. Hence, speculation tends to predominate the enterprise in the stock market.

Whereas, it cannot be denied that the activities in the stock exchange act as a barometer indicating the changes in the economic weather even then, such activities fail to give correct valuation of the existing stock, share and security. The process of evaluation is highly defective because a large number of psychological, social, political and institutional factors influence its determination. In other words, these factors get undue importance over the purely economic factors.

Keynes criticized the professional dealer, who is more concerned with earning quick profits rather than genuine enterprise. He felt that, if the activities in the stock exchange were more genuine (than of speculative nature), correct values of securities would be reflected and they could serve as a good guide to intending investors. But in actual practice, stock exchange quotations suffer from many handicaps and fail to further a cause of private investment.

That is why Keynes remarked:

“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation.”