Investment: Marginal Efficiency Of Capital

Introduction

The purpose of this literature review is to help the reader understand better how an investment works. One thing is important to know is that for investment to occur, the capital must have been produced. In order to understand the way investment affects the circular flow of income, capital will be taken as a meaning of anything that helps the production process other than land, labour and enterprise. With this being said, the investment will have taken place when a producer buys a machine, or raw material, or rents a factory, but it will not have taken place when the producer pays his labour force, nor when he distributes profits to the shareholders, nor when he purchases a piece of land.

If the goods have been purchased for private use with no intention of using them for further production, they will be classified as consumption goods. However if the good is bought to use in the production of something else, which will then be sold, it will be classified as capital or investment.

Who is investing?

Decisions to invest depend in large part on who is doing the investing. Industrial and commercial, central and local government, public corporations and the private sector, are various sectors of investment identified by the national income statistics. This chapter however is more focused on the motivations for investment, which has been taken to mean the purchase of capital to aid future production for sale.

For the public sector, the question as to what will be the best for the country is what helps motivate the investment. The decision to buy a body scanner for a hospital is not necessarily determined by measurement of its efficiency but by the consideration of what final service the National Health Service feels it has to provide.

In this sense, there is a very small difference between such a decision and another one made by an individual to buy a car or a yacht, which will also provide a service. These kinds of government investments are called social capital which includes roads, libraries and schools. The decision in investing comes from government policy and possibly from the level of government income created by taxation.

Marginal Efficiency of Capital (MEC)

Almost all the producers measure the efficiency by how much profit can be made. To decide the level of profit they will need to know certain data about the machine they want to purchase.

1. The selling price of the machine. If the producer is borrowing money to buy the machine, he will at some point in the future have to return the borrowed money, the machine efficiency will be measured by its ability to meet the sum of debt as well as cover the other costs.
2. The yield of the machine. The yield of the machine is given by the total goods produced multiplied by the price at which they will sell.
3. The future selling price of the finished product. Due to the fact that the future prices are unknown and must be forecasted, they might face special problems, but the prices which are finally chosen will reflect both the producer’s level of confidence and his knowledge of the market.
4. Associated labour, raw material and running costs. The total yield will give the revenue received, but part of that will have to be put aside in order to pay the labour needed to operate the machine, the raw materials it processes and any other associated costs necessary to run it. Interest costs are not included here. what the producer needs to calculate is that part of the yield which can be attributed to the machine alone.
5. The estimated economic life of the machine. The product that comes from the machine in one year is not enough to cover the borrowed money for its purchase. Nonetheless, the machine goes on yielding revenue year after year, hence why it is necessary to know how many years it will take before the full production can be calculated.
6. Scrap value. Even though the machine eventually will lose its efficiency by the end of its economic life, it may be worth scrap. In order to calculate the machine’s value used up each year, the scrap value will be withheld from the supply price and the result divided by the estimated lifespan to give a yearly depreciation.
7. Interest rate. The remaining cost is that of borrowing the money to buy the machine. While this is generally thought of as a cost paid out in form of interest to the lender, it applies equally to a producer who has already saved up the money himself. Given this case, he could have lent the money and earned interest himself, instead, he has foregone the interest in order to obtain the machine. The foregone interest is the opportunity cost of his investment.

A producer has the possibility of borrowing £1000 to buy a machine. What rate of interest will he be able to pay when he uses the machine? He estimates the first six categories of data as follows:

1. Supply price £1000
2. Yield/year £2000
3. Future market price Stable
4. Associated costs £1700
5. Life-span of machine 5 years
6. Scrap value £500

Once the associated running costs have been deducted from the yield(£2000- £1700) the producer will have £300/year available to pay back the borrowed capital and pay the interest rate. The exact rate of interest he will be able to afford will depend on how he arranges to borrow the money. If he agreed to pay interest each year on the full sum and then pay back the full sum at the end of the fifth year he could afford to pay 20 per cent interest per annum.

• Total available revenue at £300/year £1500
• +Scrap value at end of Year 5 500
• Total returns to machine £2000
• -Repayment of capital in Year 5 – £1000
• Monies available to pay interest £1000
• Monies available to pay interest/year = £ 200
• As% of the borrowed sum of £1000 = 20%

Marginal Efficiency of Capital (MEC) Curve

If the project is considered profitable after the producers have done their evaluation on all investment projects separately, they will decide to invest. In our case, we are dealing with a series of machines and this can be considered as represented by successive units of capital along the bottom axis. At K all machines between 0 and K will be efficient enough to cover the interest rate I, so they will be purchased.

The producers will now consider whether or not to buy the next unit, say K₁. This next unit is termed the marginal unit, and, as each is considered in turn with reference to its efficiency, the demand curve as a whole is termed the marginal efficiency of capital. This lets us know that at an interest rate of i the marginal unit K is just efficient enough to cover an interest rate of i, so the producers will employ it. The next unit K₁ is not efficient enough to cover this interest rate, so it will not be employed unless the interest rate falls to i₁.

Why does the MEC curve slope downwards from left to right?

What this question is really asking is why the use of additional machines will make them less efficient than those already in use. There are numerous reasons why this will occur.

1. The law of diminishing returns. The factory space or management may be the fixed factor in our case. However, capital is clearly the variable factor. As we add more variable factors to the fixed factor, each additional unit of the variable factor will add less production than the previous unit added, i.e., the yield will fall.
2. The supply price of the machine. As we know from the law of Supply and Demand, the more machines are ordered the more demand in the machine-making industry will increase, hence why the price of them will rise.
3. The yield. Due to the standardization of today’s machines, the Law of Diminishing Returns may not be as simple in the application as the theory suggests. Nonetheless using more machines will help increase the supply of the finished products on to the market. In order to sell this additional supply, lowering the market price will be necessary, and hence the yield per machine.
4. The associated costs. Additional labour will be needed to run the additional machines. This will cause an increase in on-demand in the labour market at the same time putting up wage rates. The same argument applies to the other associated costs.
5. Scrap values. If there are additional machines being used, there will be more of them being scrapped in the future. Given this, the scrap merchant will offer a lower price.

Shifts in the MEC Curve

Like any other demand curve, the MEC curve can shift from one position to another if the condition that determine it’s efficiency change(Fig.1.1).If for example the demand for the finished product increased, causing a rise in the price, then the yield on all machines would rise. The k-th unit could now support a rate of interest of i₂ instead of i₁.As the demand for the finished product increases, all units of capital will be more efficient so the entire MEC curve will shift to the right. If i₁ remains the prevailing interest rate, then K₁ units of investment will now be profitable.

The investment function

In order to discover how the level of investment is related to the national income, it is necessary to make a few changes in the level of the national income and assess how investment would respond.From the MEC analysis it is safe to assume that there will be a positive correlation.This reliance of the level of investment upon the level of national income may be expressed as:

I= ƒ (y)

According to this equation, the investment depends upon the level of income.

The Acceleration Principle

The demand for his product and how that is changing is what’s important for the individual producer.Therefore we restate the investment function in terms of how it changes the level of investment.

ΔI= ƒ(ΔC)

Where ΔI is the change in investment and ΔC is the change in consumption.The principle which shows this relationship is called the acceleration principle and this gives the value of ƒ.

The effect on employment and physical output

Let us assume that a manufacturer of cloth requires one loom for each 10 feet of cloth he produces per hour.This represents the capacity of the machines.At present he has orders for cloth that come to 200 ft/h.He will therefore need 20 machines.Through years of experience he has decided that the optimum time to keep a machine before replacing it is 10 years, and in order to spread the burden of replacement costs he has arranged the replacements to occur regularly, at two machines per year.

We will now assume that in the second year there is an increase in people’s incomes and the demand for this producer’s cloth rises from 200 ft/h to 220 ft/h.To meet this increase in demand he will now need 22 machines.At the end of the first year two of his machines required replacement, leaving him with only 18 machines.To reach the 22 machines he now has to order four new machines.For acceleration to occur we have to consider a situation where the rise in demand for machines is kept at the same level.A situation to be considered is where the demand for the machines would have to go on increasing by two each year.For this to happen there has to be a rise in the demand for the finished product at an accelerating rate.

A comparatively small change In the consumer goods industry has a devastating impact on the producer goods industry. By changing the basic data and observing how that alters the relationship is the way to forecast which industries are most likely to be affected by this acceleration process. The two factors held fixed were the capacity and the lifespan of the machine.

The capacity

If we assume that the capacity of the machines is only 5 ft/h instead of 10 ft/h, meeting the original demand of 200 ft/h will take 40 machines. Seeing that they last for ten years, four will need replacing each year, therefore, reducing the stock of machines to 36. In order to meet the demand of 220 ft/h of cloth the producer will need eight new machines. This makes it known that the percentage change in investment demand is not dependent upon the capacity of the machines.

The life-span

Ten years was the original life span of the machines. If we assume that they last for only five years and with capacity being held constant we will have the same number of machines. Nevertheless, it will be necessary for four machines to be replaced instead of two because they only last for five years. The changes in consumer demand have on the production and employment in the producer goods industry depends on the lifespan of the machines and not on their capacity.

The investment depends on the level of consumer demand, and hence on the level of income. While explaining the impact on employment and output in physical rather than monetary terms, the investment function should be written as:

Proportional ΔI= γ (proportional ΔC)

In this equation, γ is a coefficient, which computes the effect that changes in consumer demand will have on the level of employment, or output, in the investment industry.

The dampened accelerator

‘Dampeners’ is a term used for factors that lower the impact, i.e., lower the value of –y. They can be found in both the consumer goods industry and the producer goods industry.

In the consumer goods industry

Our model has assumed that the producer will rush into buying another machine as soon as the demand for consumer goods rises. However, there are many reasons why that shouldn’t happen.

1. Stocks. Most producers of finished goods will either hold stocks themselves or see that wholesalers and retailers hold stocks. The running down of stocks would be the result of an increase in demand.
2. Confidence. Buying long-lasting machines the moment the demand for the product goes up would be a foolish decision. Clever producers would wait to see if the change in demand is more than a temporary coincidence before making long-term investment plans.
3. Capacity. The fact that machines may not be working to capacity has not been considered by our model. In this case, it may be possible to meet the increased demand by increasing the machines’ speed, working overtime or running shifts, etc.
4. Raising prices. Due to insufficient stocks or capacity to meet the increased demand, a producer may be induced to put up the price. The extent to which this can be done will depend upon the reactions of his competitors and is much more likely in monopoly conditions.
5. Full capacity. The ultimate constraint on increasing production in the short run is the existence of fixed factors such as the factory building itself. Can new machines be fitted into the building? To overcome this by, say, moving to new premises introduces yet another time lag.

In the producer goods industry

The assumption that the production of the finished good was too rigid and could not respond to changes in demand by providing extra production from existing machines has been mistakenly made. In the producer goods industry, the model has assumed the exact opposite, I.e., if required, the industry could suddenly double its output. Again there are many reasons why this would not happen.

1. Full capacity. In making new machines, additional labour, raw materials, and possibly a new plant will be required. In certain conditions, full employment will act as a final constraint to meeting new machine demand, and that will be overcome by taking factors away from productions.
2. Raising prices. The making of a piece of capital takes longer than the making of finished products. Therefore it is necessary to order machines and wait for their production. With this being a time lag, the only way to get around is to buy it at a higher price. The manufacturer of the machines being profit-maximizing may react to the increase of the demand by increasing the prices of the machines rather than the number he sells.
3. Redundancy pay. It is wrong to suppose that output and employment automatically move together. Compelling employers to compensate the terminated employees has discouraged employers from dismissing men when demand for the product falls. Eventually, bankruptcy would force men out of work.
4. Training. Skilled work is going to be needed if the producer firms take on more employees to make machines. This would mean a training period before labour is skilful and slow down the ability of producers to react to extra demand for machines.

Conclusion

Investment means buying capital for it to help in future production for sale. It depends upon the level of consumer demand, and hence on the level of income.

For us to measure the efficiency of the capital, we have to consider: The selling price of the machine, the yield of the machine, the future selling price of the finished product, associated labour, raw material and running costs, scrap value and the interest rate. If the project is considered profitable, the producers will invest.

It is important to know that additional machines will lower efficiency due to numerous reasons:

The law of diminishing returns, the supply price of the machine, the yield, the associated costs and scrap values.

References

1. John Evans-Pritchard (1985),” Macroeconomics: An introductory text”