The marginal efficiency of capital along with the rate of interest determines the amount of new investment. which in turn, determines the volume of employment, given the propensity to consume. In the fundamental equation Y = C +I, given by Keynes, we have seen that income at a time depends upon consumption and investment. Consumption is stable in the short run gap comes to exist which can be wiped off only by an increase in investment.
Investment is an essential requirement for full employment and the key to prosperity in a capitalistic economy. This is so widely and generally recognized by all economic schools and sects that it may be regarded as an axiom of modern economics. Not only investment, but an increasing rate of net investment is necessary to assume continued full employment.
Marginal efficiency of capital refers to the anticipated rate of profitability of a new capital asset. It is the expected rate of return over cost from the employ of an additional unit of a capital asset. Marginal efficiency of capital depends upon the expected rates of return of a capital asset over its lifetime (called prospective yield by Keynes) and the supply price of the capital asset.
It must be remembered that a businessman while investing in a new capital asset will always weigh the expected rates of net return (profitability) over the lifetime of the capital asset (say a machine) against its supply price (cost) also called “replacement cost” ‘if the former is greater than the latter. the businessman will invest. otherwise not.
