Difference Between MEC and MEI: Marginal Efficiency of Capital vs Marginal Efficiency of Investment | Macroeconomics
If you are studying macroeconomics, you have likely come across two terms that sound almost the same but mean different things: Marginal Efficiency of Capital (MEC) and Marginal Efficiency of Investment (MEI). Many students mix these two up because both deal with the return on capital investment.
This guide breaks down what each term means, how they work, and the 10 major differences between MEC and MEI in simple, easy to understand language.
What is Marginal Efficiency of Capital (MEC)?
Marginal Efficiency of Capital (MEC) is the rate of discount that makes the present value of the expected income from a capital asset equal to its supply price, or cost of capital. In simple words, it is the expected rate of return on one more unit of capital.
The British economist John Maynard Keynes first introduced the concept of MEC in his 1936 book, The General Theory of Employment, Interest and Money (Keynes, 1936). Keynes described MEC as one of the main forces that drives autonomous investment in an economy.
Key points about MEC:
- MEC measures the extra output produced by one more unit of investment.
- It is based on the productive capacity of capital goods and the expected return on them.
- MEC falls as total capital investment rises, because each new unit of capital tends to earn a lower return than the one before it.
- Firms compare MEC with the cost of capital (interest rate) before investing. If MEC is higher than the interest rate, the investment is considered worthwhile.
What is Marginal Efficiency of Investment (MEI)?
Marginal Efficiency of Investment (MEI) is the expected rate of return on an additional unit of investment made under current market conditions over a set period of time. It is closely related to MEC but focuses on the flow of new investment rather than the total stock of capital.
The basic formula for MEI is:
MEI = (ΔY / ΔI) x 100
Where:
- ΔY = change in output
- ΔI = change in investment
Key points about MEI:
- MEI shows how much extra output a firm or economy gets from new investment.
- It depends on the production function and the demand for the firm’s output.
- A higher MEI means the firm or economy is using its resources more efficiently.
- MEI can change due to shifts in technology, interest rates, taxes, and market risk.
- Firms use MEI to decide which projects to fund, choosing the ones with the highest expected return.
Real Life Example of MEC and MEI
Imagine a bakery owner is thinking about buying a new oven. The expected extra profit from that one oven, compared to its cost, reflects the MEC of that investment. Now imagine the bakery owner wants to buy five more ovens in the same year.
As more ovens are added, each new oven adds slightly less extra profit than the last one, because the market for baked goods can only absorb so much more supply. This declining return on each additional oven purchased in the same period reflects the MEI.
10 Major Differences Between MEC and MEI
| No. | Basis of Difference | Marginal Efficiency of Capital (MEC) | Marginal Efficiency of Investment (MEI) |
|---|---|---|---|
| 1 | Price basis | MEC is based on a given, fixed supply price of capital. | MEI is based on the change in price caused by a change in the demand for capital. |
| 2 | Scope of return | MEC represents the rate of return on all units of capital, without separating old and new capital. | MEI shows the rate of return only on new units of capital added over the existing capital stock. |
| 3 | Graph representation | The horizontal axis shows the total capital stock. | The horizontal axis shows the amount of new investment. |
| 4 | Type of concept | MEC is a stock concept, measured at one point in time. | MEI is a flow concept, measured over a period of time. |
| 5 | What it determines | MEC determines the optimum, or ideal, capital stock in an economy at each interest rate. | MEI determines the actual net investment in the economy at each interest rate, given the existing capital stock. |
| 6 | Time horizon | MEC looks at the long run expected return from a capital asset over its entire life. | MEI focuses on the short run return during a specific investment period. |
| 7 | Main influencing factors | MEC is mainly influenced by the prospective yield of a capital asset and its supply price. | MEI is mainly influenced by the interest rate, investment demand schedule, and rising costs of new capital goods. |
| 8 | Behavior of the curve | The MEC curve is generally more stable and less steep. | The MEI curve tends to be steeper because the supply price of capital goods rises faster as investment increases quickly. |
| 9 | Origin of the concept | MEC was introduced by John Maynard Keynes in 1936. | MEI was developed later by economists to refine Keynes’s original idea and account for rising supply prices during rapid investment. |
| 10 | Practical use | MEC is used to explain the general theory of investment and capital formation. | MEI is used by firms and policymakers to make real, day to day investment decisions. |
Why the Difference Between MEC and MEI Matters
Understanding the difference between MEC and MEI helps students and business owners see why investment does not happen all at once, even when returns look attractive.
MEC gives a broad, long term picture of capital efficiency, while MEI gives a more realistic, short term view that accounts for rising costs when investment happens quickly.
Both concepts help explain how interest rates, government policy, and market conditions shape investment decisions in an economy.
Factors Affecting Marginal Efficiency of Investment (MEI)
Several factors can raise or lower MEI over time:
- Interest rates: Lower interest rates make borrowing cheaper, which can raise MEI.
- Inflation: Rising prices can reduce the real return on investment, lowering MEI.
- Taxes: Higher taxes reduce the funds firms have available to reinvest.
- Technology: New technology can boost output per unit of investment, raising MEI.
- Political stability: Unstable governments make it harder to secure loans and plan long term projects, which can lower MEI.
Frequently Asked Questions (FAQs)
1. What is the main difference between MEC and MEI?
MEC measures the return on the total stock of capital based on a fixed supply price, while MEI measures the return on new investment as demand and prices change over a set period.
2. Are MEC and MEI the same thing?
No. MEC and MEI are related but different concepts. MEC is a stock concept covering all capital, while MEI is a flow concept covering only new investment.
3. Who introduced the concept of Marginal Efficiency of Capital?
John Maynard Keynes introduced MEC in his 1936 book, The General Theory of Employment, Interest and Money (Keynes, 1936).
4. What is the formula for MEI?
The formula for MEI is MEI = (ΔY / ΔI) x 100, where ΔY is the change in output and ΔI is the change in investment.
5. Is MEC a stock or a flow concept?
MEC is a stock concept because it looks at the total existing capital at one point in time, not new investment over a period.
6. What factors affect the Marginal Efficiency of Investment?
Interest rates, inflation, taxes, technology, and political stability are the main factors that affect MEI.
7. Will a firm invest if its MEI is 15 percent and the cost of borrowing is 10 percent?
Yes, in general a firm will invest when MEI is higher than the cost of borrowing, since the investment is expected to earn more than it costs to fund.
8. What is the relationship between MEC and the rate of interest?
There is an inverse relationship between MEC and the rate of interest. When MEC is high, firms are more willing to invest even at a higher interest rate. When MEC is low, firms only invest if the interest rate is also low.
9. Why does MEC decline as investment increases?
MEC declines because each additional unit of capital tends to add less extra output than the one before it, a pattern known as diminishing returns.
10. How do businesses use MEC and MEI in real investment decisions?
Businesses compare MEC and MEI against the current interest rate or cost of borrowing. If the expected return is higher than the cost of capital, the investment is considered worthwhile.
Conclusion
MEC and MEI are two closely linked but distinct concepts in macroeconomics. MEC looks at the broad, long term return on the entire stock of capital, while MEI focuses on the short term return from new investment as market conditions shift.
Knowing the 10 differences between them makes it easier to understand how interest rates and investment decisions shape economic growth.
References
Ahuja, H. L. (2018). Macroeconomics: Theory and policy. S. Chand Publishing.
Dornbusch, R., Fischer, S., & Startz, R. (2018). Macroeconomics (13th ed.). McGraw-Hill Education.
Jhingan, M. L. (2011). Macroeconomic theory (12th ed.). Vrinda Publications.
Keynes, J. M. (1936). The general theory of employment, interest and money. Macmillan.
Disclaimer: This article is for general educational purposes only and is meant to simplify economic concepts for students. It should not be treated as professional financial or investment advice.
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