Marginal Efficiency of Capital and Investment in Business

Sunday, February 7, 2010

Marginal efficiency of capital and rate of interest are the main factors which affect investment. Demand analysis is the basic aspect of investment.

Marginal Efficiency of Capital (MEC) – Any investment decision depends not only on rate of interest but also whether or not the expected rate of returns on the investment is greater than cost of borrowing the funds. In these two factors, the MEC is an important factor because MEC is the expected rate of returns from the investment. If the returns expected are low, then the investment is not profitable because in short run, rate of interest is stable. In MEC, capital means the real productive assets. MEC depends on expected rate of returns of a capital asset over its life time which is also called Prospective Yield and the supply price of capital assets. Any business man will weigh the prospective yield with the supply price before investing.

Investment and rate of interest: Rate of interest is considered the most important factor in investment will be low and vice-versa. This was a view given by classical economists. They considered rate of interest as the only factor determining investment.

MEC, Rate of Interest and Investment Decisions:

The businessmen will decide whether to purchase on the marginal unit of capital by comparing the prevailing rate of interest with the MEC.

If MEC Rate of interest, this additional investment will get profit and investment is profitable.

MEC Affecting MEC:

There are some short term and some long term factors.

Short term – Under these factors are:

Expected Demand for Future

Level of Income

When Consumption Changes

Business Expectation

Long Term Factors:

Population Growth

Economic Policies of Government

Infrastructures facilities

Limitation of MEC:

Investment done by the Government for social purpose has no connection with the MEC.

Practically it is difficult to estimate MEC.

Whenever there is contractionary monetary policy, the firms may not find funds even if the projects or investments are profitable

Every time the businessmen do not necessarily go for loans. Sufficient funds are gathered by the businessmen for some projects, which are planned for a long time.

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