Keynes Marginal Efficiency Of Capital

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Marginal Efficiency of Capital

There is an alternative view of the investment decision-making process which clearly stresses importance of ht market rate of interest.

Under the present value approach, the comparison is between the present value (PV) of the future income stream associated with the investment project and the cost of the project, C.

Under the alternative approach, the comparison is made between the expected rate of return r and the market rate of interest i. If market rate o interest is greater than the expected rate of return, the investment project will be unprofitable. If, on the other hand, the expected rate of return is greater than the market rate of interest, the project will be profitable.

The rate of return can be determined by using the following equation:

Cr = R1/ (1 + r) +R2 / (1 + r)2 + ... + Rn / (1 + r)n

where R1, R2....R3 are the prospective returns expected at the end of 1, 2,..., n years, Cr is the supply price or the replacement cost of the capital asset, and ‘r’ is the rate of return expected from the capital asset. Thus, if we know Cr, R1, R2,....Rn, we can find a unique value for ‘r’ which will satisfy the equation.

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