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MEC & MEI

Oct 28, 20243 min read

The sources discuss Marginal Efficiency of Capital (MEC) and Marginal Efficiency of Investment (MEI), two important concepts in investment theory.

Marginal Efficiency of Capital (MEC):

  • MEC refers to the expected rate of return over cost from an additional unit of a capital asset.
  • It is the discount rate that equates the present value of the expected future returns from the asset to its supply price (cost).
  • The MEC curve generally slopes downward, implying that as the capital stock increases, the rate of return on additional capital declines due to diminishing returns.
  • The optimum capital stock for an economy is determined where the MEC equals the market interest rate.

Marginal Efficiency of Investment (MEI):

  • MEI is the expected rate of return from a given investment on a capital asset after covering all costs except the interest rate.
  • It differs from MEC in that it considers induced changes in the supply price of capital, while MEC assumes a given supply price.
  • The MEI schedule depicts the relationship between the interest rate and the amount of investment demanded.
  • Like the MEC curve, the MEI curve also generally slopes downward, meaning higher interest rates lead to lower investment demand.

It’s essentially the profitability of investing in more capital goods, like machinery or buildings, and indicates how effectively a firm’s investment is expected to increase its output and profits.

Example of MEI

Factory manager buys a new machine for $100,000 to increase production and generate an extra $20,000 in annual net earnings.

Expected service life: 10 years

Compare the use of this $100,000 on other potential uses or the interest rates they would incur if they borrowed the money.

Relationship Between MEC and MEI:

  • The sources emphasize the distinction between MEC (a stock concept) and MEI (a flow concept).
  • MEC determines the desired capital stock at a given interest rate, while MEI determines the net investment needed to adjust the actual capital stock toward that desired level.1
  • The shapes of the MEC and MEI curves are influenced by the supply conditions in the capital goods industry.
    • Under constant costs, the MEI curve will be perfectly elastic (horizontal).
    • Under increasing costs, the MEI curve will slope downward, reflecting rising capital goods prices as investment increases.
  • The sources explain how adjustments in the capital stock and investment occur over time through shifts and movements along the MEC and MEI curves in response to changes in interest rates.

Understanding the concepts of MEC and MEI, and their relationship, is crucial for analyzing investment decisions and the dynamics of capital accumulation in an economy.

Footnotes

  1. This is key. Desired capital stock for the profitability. MEI determines how to get there. ↩

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