The Marginal Efficiency of Capital

When a man makes an investment, he buys the right to prospective returns.

I call this “the prospective yield of the investment”.

This prospective yield has a supply price which is the cost to create that investment.

This supply price is not the market price at which it is bought.

The relation between the prospective yield and its supply price gives us its marginal efficiency of capital.

• It is equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price.
• It is the expectation of yield and of the current supply price of the investment.
• It is not based on the historical result of what an investment has yielded.

This marginal efficiencies for each kind of investment.

The greatest of these marginal efficiencies can then be regarded as the marginal efficiency of capital in general.

If more people buy ann investment over time, the marginal efficiency of that kind of investment will diminish.

This is:

• because the prospective yield will fall as the supply of that type of capital is increased, and
• This is takes place in the long run
• partly because as a rule, pressure on the facilities for producing that type of capital will cause its supply price to increase.
• This is takes place in the short run

Thus for each type of capital we can build up a schedule

We show how much investment in it will have to increase within the period, for its marginal efficiency to fall. We then aggregate these curves for all types of capital to create a curve. This will show the rate of aggregate investment to the corresponding general marginal efficiency of capital established by that rate of investment.

The actual rate of current investment will then be reduced to the point where there is no longer any investment which has the marginal efficiency to exceed the current rate of interest.

The rate of investment will be pushed to the point on the investment demand curve where its prospective returns are equal to the market rate of interest.

The demand price of the investment at equilibrium = Summation of the prospective yield from an asset at given timespan multiplied by the Present value of £1 deferred at that timespan at the current rate of interest.

Investment will be carried to the point where the demand price of the investment becomes equal to the supply price of the investment. If the demand price of the investment falls goes below the supply price, investment will stop.

It follows that the inducement to invest depends partly on the investment demand-curve and partly on the rate of interest.

The conclusion of Book 4 has a comprehensive view of the factors determining the rate of investment in their actual complexity. Neither the knowledge of an asset’s prospective yield nor the knowledge of the returns of the investment enables us to deduce either the rate of interest or the present value of the asset. We must ascertain the rate of interest from some other source. Only then can we value the asset by “capitalising” its prospective yield.

The Marginal Productivity / Yield / Efficiency / Utility of Capital are familiar terms. We have to clear 3 ambiguities:

Ambiguity 1:

Are we concerned with the increment of product per time due to the employment of a unit of capital?

This involves impossible difficulties as we have to define the physical unit of capital.

We could say that 10 labourers will raise more wheat if they had more machines. But I don’t know how to reduce this to an arithmetical ratio which does not bring in values.

Or are we concerned with the increment of value due to the employment of one more value unit of capital? [quantity vs quality]

Ambiguity 2:

Are return on invesments some absolute quantity? Or is it a ratio?

It should be a ratio since it is relative to the rate of interest.

Yet it is not usually clear what the two terms of the ratio should be*.

Ambiguity 3:

There is the distinction between:

• the increment of value obtainable from an additional capital in the existing situation, and
• the series of increments which the capital is expected to obtain over its lifetime.
  • That is, the distinction between Q1 and the complete series Q1, Q2..

This leads to the idea of expectation in economic theory.

Most discussions of the return on investment only focus on Q1.

• This is only legitimate in a static theory where all Q’s are equal.

The ordinary theory of distribution assumes that capital is now getting its marginal productivity. This is only valid in a stationary state.

The aggregate current return on investments has no direct relationship to the return on investment while its current return, when the investment was theorized, is its cost to the investment seller.

The theorized return created by the investment seller also has no close connection with its actual return [proven by crashes].

There is a remarkable lack of any clear account of the matter.

Marshall uses the term:

• “marginal net efficiency” of a factor of production or
• “marginal utility of capital”.

A factory adds £100 worth of machinery to add £3 net output.

• If this is the most optimum investment at equilibrium, then it means that the yearly rate of interest is 3%.
• But this is indicates a part of the many causes which govern value.

They cannot be made into a theory of interest, any more than into a theory of wages, without reasoning in a circle.

If the rate of interest is 3%, hat-making absorbs £1m.

• It means that hat-making will be able to turn the £1m into a value of over £1.03m.
• This is why the investors paid 3% to get that £1m to put into hat-making.

If the rate is 20%, then less hat-making machinery would be bought that if the rate were 6% or 4%.

Thus, if the rate is 3% and hat-making absorbs capital then it means that the marginal utility of the hat-making machinery is at 3%.

Marshall knew that we are reasoning in a circle if we try to determine what the interest rate actually is.

[2] He accepts that the interest rate determines the point to which new investment will be pushed, given the return-on-investment curve.

If the rate of interest is at 3%, then no one will pay £100 for a machine unless he hopes thereby to add £3 to his annual net output.

But Chapter 14 shows that in other passages Marshall was less cautious — though still drawing back when his argument was leading him on to dubious ground.

Professor Irving Fisher does not call it the “marginal efficiency of capital”.

• He has an equal term as “the rate of return over cost” in his Theory of Interest (1930).