A cut in interest rates from R1 to R2 will increase investment to I2.
The alternative to investing is saving money in a bank, this is the opportunity cost of investment. If the rate of interest is 5% then only projects with a rate of return of greater than 5% will be profitable.
Factors which shift the Marginal Efficiency of Capital
- The cost of capital. If capital is cheaper, then investment becomes more attractive. For example, the development of steel rails made railways cheaper and encouraged more investment.
- Technological change. If there is an improvement in technology, it can make investment more worthwhile.
- Expectations and business confidence. If people are optimistic about the future, they will be willing to invest because they expect higher profits. In a recession, people may become very pessimistic, so even lower interest rates don't encourage investment. (e.g. during recession 2008- 12, interest rates were zero, but investment low)
- Supply of finance. If banks are more willing to lend money investment will be easier.
- Demand for goods. Higher demand will increase profitability of capital investment.
- Rate of Taxes. Higher taxes will discourage investment. Sometimes, governments offer tax breaks to encourage investment.
Determinants of Marginal efficiency Capital
Marginal efficiency of Capital is governed by the expected yield of a capital asset and its supply price. In technical term the same are called:
It is the aggregate net return expected from it during its whole life. In order to determine prospective yield, annual return of the capital is worked out. Aggregate of annual return expected from a capital asset over its life-time is called total prospective yield. The remainder, after deducting cost of production from total revenue earned by the sale of output produced with the help of capital asset, is called prospective yield. With rise in prices, prospective yield increases and with the fall in prices, it decreases. Prices are likely to change in the be expressed in terms of the following equations: Py = Q1 + Q2 + Q3 + Q4 +«««+ Qn (Here Py= Prospective Yield; Q1, Q2, Q3, Q4 and Qn = net revenue received in the first, second, third, fourth and nth year)
Supply Price :
The other factor influencing M.E.C. of a capital asset is its supply price. The supply price of a capital asset is the cost of producing a new asset of that kind, not the supply price of an existing asset. Hence, the supply price of a capital asset is also called Replacement Cost. It remains fixed in the short period.