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💸principles of economics review

Marginal Efficiency of Capital

Written by the Fiveable Content Team • Last updated September 2025
Written by the Fiveable Content Team • Last updated September 2025

Definition

The marginal efficiency of capital is a concept in Keynesian economics that refers to the expected rate of return on an additional unit of capital investment. It represents the profitability of investing in new capital goods and is a key factor in determining the level of investment in the economy.

5 Must Know Facts For Your Next Test

  1. The marginal efficiency of capital is the expected rate of return on the last unit of capital investment, which decreases as more capital is added to the production process.
  2. It is influenced by factors such as the current level of output, the cost of capital goods, and expectations about future demand and prices.
  3. A higher marginal efficiency of capital encourages investment, as it indicates that the expected return on new capital investment is greater.
  4. In Keynesian analysis, the level of investment is a key determinant of aggregate demand and economic growth.
  5. The marginal efficiency of capital is closely related to the concept of the investment multiplier, which describes how changes in investment can lead to larger changes in output and income.

Review Questions

  • Explain how the marginal efficiency of capital is related to the level of investment in the economy.
    • The marginal efficiency of capital represents the expected rate of return on an additional unit of capital investment. When the marginal efficiency of capital is high, it indicates that the expected return on new investment is greater, which encourages firms to invest more in capital goods. This increased investment then leads to a rise in aggregate demand and economic growth, in accordance with the Keynesian framework. Conversely, a lower marginal efficiency of capital would discourage investment, as the expected returns on new capital would be less attractive.
  • Describe how the marginal efficiency of capital influences the investment multiplier in Keynesian analysis.
    • The marginal efficiency of capital is closely linked to the investment multiplier in Keynesian economics. The investment multiplier describes how a change in investment can lead to a larger change in output and income. When the marginal efficiency of capital is high, it indicates that the expected returns on new investment are greater, which encourages firms to invest more. This increased investment then has a multiplier effect, as the additional spending leads to higher incomes, which in turn generates more consumption and further investment. The size of the investment multiplier is directly related to the marginal efficiency of capital, as a higher marginal efficiency of capital amplifies the impact of changes in investment on the overall level of economic activity.
  • Analyze how changes in the marginal efficiency of capital can impact the aggregate demand curve in Keynesian analysis.
    • In the Keynesian framework, the marginal efficiency of capital is a key determinant of the level of investment, which is a crucial component of aggregate demand. When the marginal efficiency of capital increases, it signals that the expected returns on new investment are higher, encouraging firms to invest more. This rise in investment leads to a rightward shift in the aggregate demand curve, as the increased spending on capital goods adds to the overall demand for goods and services in the economy. Conversely, a decrease in the marginal efficiency of capital would discourage investment, causing the aggregate demand curve to shift leftward. These changes in the marginal efficiency of capital and their impact on investment are central to Keynesian analysis of economic fluctuations and the role of fiscal and monetary policies in stabilizing the economy.