Investment, in the theory of income and employment, means, an addition to the nation’s stock of capital like the building of new factories, new machines as well as any addition to the stock of finished goods or the goods in the pipelines of production.  Investment includes addition to inventories as well as to fixed capital.  Thus, investment does not mean purchase of existing securities or titles, i.e., bonds, debentures, shares, etc.  Such transactions do not add to the existing capital but merely mean change in ownership of the assets already in existence.  They do not create income and employment.  Real investment means the purchase of new factories, plants and machineries, because only newly constructed or created assets create employment or generate income.

Types of Investment:

  1. Gross and Net Investment: Net investment means gross investment minus depreciation.  In the theory of income and employment, investment means net investment.
  1. Ex-ante and Ex-poste Investment: Ex-ante investment is planned or anticipated investment.  Ex-post investment is actually realised investment, or the investment which is not merely planned but which is actually invested or implemented.
  1. Private and Public Investment: Private investment is on private account and public investment is by the State or local authorities.  The private investment is influenced by marginal efficiency of capital (MEC) i.e., profit expectations and the rate of interest.  Therefore, the private investment is profit-elastic.  In public investment, the profit motives do not enter into consideration.  It is undertaken for social good and not for private gain.
  1. Autonomous and Induced Investment: Autonomous investment is independent of income level, and depends on population growth and technical progress.  Such investment does not vary with the level of income.  In other words, it is income-inelastic.  The influence of change in income is not altogether ruled out.  The examples of autonomous investment are ‘long range’ investments in houses, roads, public buildings and other forms of public investment.  Such investment is generally done by the State as necessitated by the growth of population and facilitated by technical progress and not as a result of change in NI.  These investments are independent of changes in income and are not governed by profit motive.  They are generally made by governments and local authorities for promoting general welfare.

Induced investment varies with NI.  Changes in NI bring about changes in aggregate demand which in turn affects the volume of investment.  When NI increases, AD too increases, and investment has to be undertaken to meet this increased demand.  Thus induced investment is income-elastic.

Investment is made by the people as a result of changes in income level or consumption.  It is also influenced by price changes, interest changes, etc., which affect profit possibilities.  It is undertaken for the sake of profit or income and it changes with a change in income.  Thus, induced investment is governed by profit motive.

Factors Affecting Investment:

  1. Marginal Efficiency of Capital (MEC) or expected rate of profit: MEC or expected rate of profit the most important factor affecting private investment.  If the business expectations are good or if the MEC is high, more investment will be made.  On the contrary, if there is an economic depression in the country or there are bleak prospects of profits, investment will be discouraged.  Thus, the fluctuations in investment are mainly caused by the fluctuations in the MEC.
  1. Rate of interest: The second important factor affecting investment is rate of interest.  The rate of interest does not quickly change; it is more or less sticky or constant.  Hence, the inducement to invest, by and large, depends on the MEC.  For a suitable investment condition, the rate of return or profit must at least equal to rate of interest.  So long as the expected rate of return exceeds the rate of interest, investment will continue to be made.  In other words, the MEC must never fall below the current rate of interest, if investment is to be worthwhile.
  1. Excess capacity: There are some other factors that affect investment.  Excess capacity is one of them.  If a firm has already ‘excess capacity’ and can easily handle increased future demand, it will not go in for further investment in capital equipment.
  1. Technological progress: Technological progress also affects current level of investment.  For instance, a new invention may render the present capital stock of a firm obsolete and adversely affect its ability to compete.  In this case, further investment will be called for.
  1. Political and security conditions: This factor has become one of the major important factors that affect the investment, esp. with reference to under-developed countries including Pakistan.  Political instability, poor security arrangements and society’s negative attitude towards investment companies can badly damage the investment environment, and the country can be suffered from poverty and unemployment due to lack of investment.  Countries like Kenya, Zimbabwe, Sudan, etc. are the worst victims.

Marginal Efficiency of Capital (MEC):

MEC is the highest rate of return expected from an additional unit of a capital asset over its cost.  It is the expected rate of profitability of a new capital asset.  J.M. Keynes has defined MEC as being equal to the rate of discount which would make the present value of the series of annuities given by the returns expected from the capital assets during its life just equal to the supply price.  Symbolically it is expressed as:

Where Sp denotes supply price or replace cost of the asset, R1, R2,…..Rn are the prospective annual returns or yield from the capital asset in the year 1, 2, and n respectively. i is the rate of discount which makes the capital asset exactly equal to the present value of the expected yield from it.

Investment-Demand Curve:

The investment-demand schedule is also known as MEC schedule.  The MEC schedule shows a functional relationship between MEC and the amount of investment in a given type of capital asset at a particular period of time for the whole economy.


(In Million

US $)


Rate of Interest

(In %)











In the above diagram, the marginal efficiency of capital is represented by MEC curve.  It slopes downward from left to right which means that as investment increased its marginal efficiency goes down.

Investment at any time depends on the rate of interest prevailing at that time.  If the rate of interest is 5%, the investment is US $750 million, because, at this level, MEC is equal to the rate of interest.  The MEC represents the investor’s return and the rate of interest is his cost.  Obviously, the return on capital must at least be equal to the rate of interest, which is its cost.  Suppose the rate of interest goes down to 3%, then it will become worthwhile to invest US $1,000 million.  Thus, the MEC and the rate of interest move together.

Position and Shape of MEC Curve: The elasticity of MEC determines the extent to which the volume of investment would change consequent upon changes in the rate of interest.  If MEC is relatively interest-elastic, a little fall in the rate of interest will result in a considerable expansion in the volume of investment.  On the other hand, if the MEC is relatively interest-inelastic, then a considerable fall in the rate of interest may not lead to any increase in the volume of investment.

Shifts in MEC: As the expectations regarding the prospective yields change, the MEC will change too and the MEC curve will shift upwards or downwards.  It is illustrated in the following diagram:

Suppose a war breaks out or demand for goods increases on account of some other reason.  As a result, entrepreneurs’ expectations of profit will rise high and the investment demand curve or the MEC curve will shift upwards to MEC’.  This means that at a given rate of interest, investment will be greater than before.  From the above diagram, it will be seen that whereas the rate of interest i, investment was OM before, it now becomes OM’.  Similarly, if for some reason demand for goods has decreased bringing down the MEC to MEC” at the same rate of interest i, investment will only be OM” as compared with OM before.

Influence of Rate of Interest: The rate of interest along with the MEC determines the volume of investment.  If the rate of interest is higher than the MEC, it will not be profitable to create a new physical asset.  This is because we assume that the aim of individual investor is to maximise the money profits.  Two courses of action are open to invest, either he can use his money to crease additional physical assets, i.e., he can invest in the Keynesian sense of the term, or else he can lend his money to others at a certain rate of interest.  Now, if MEC is lower than the current rate of interest, it is more profitable to lend money rather than use it for creating new assets.  On the other hand, if MEC is higher than the rate of interest, it is better to invest more.  At the point, where MEC equals the current rate of interest, we have the equilibrium level of investment.

Factors of MEC:

The marginal efficiency of capital depends upon psychological and objective factors:

  1. Psychological Factors: Whenever a firm undertakes an investment, it estimates its MEC in the light of the experience of the past, existing conditions and guesses about the future conditions.  If the businessmen are optimistic about the future, they will estimate the MEC higher and if they are pessimistic about the further business condition, naturally the MEC will be estimated low.
  1. Objective Factors:

(a)   MEC and the Market: If the market of a particular commodity is wide and is expected to grow further, the investment in that project will be favourable and the MEC high.  On the other hand, if the demand of a particular commodity is limited and is expected to decline in the future, the investment will be discouraged in that project and the MEC will be low.

(b)   Rate of Growth of Population: MEC is also influenced by the rate of growth of population.  If population is growing at a rapid speed, it is usually believed that the demand of various classes of goods will increase.  So a rapid rise in the growth of population will increase the MEC and a slowing down in its rate of growth will discourage investment and thus reduce MEC.

(c)   Technological Development: If inventions and technological development take place in the industry, the prospect of increase in the net yield brightens up.  For example, the development of automobiles in the 20th century has greatly stimulated the rubber industry, the steel and oil industry, etc.  So we can say that inventions and technological developments encourage investment in various projects and increase MEC.

(d)   Existed Capital Goods: If the quantity of any particular type of goods is available in abundance in the market and the consumers can partially or fully meet demand, then it will not be advantageous to invest money in that particular project.  So in such cases, the MEC will be low.

(e)   Current Rate of Investment: Another influence on the MEC is the rate of investment currently going on in a particular industry.  If in a relevant field, much investment has already taken place and the rate of investment currently going on in that industry is also very large, then new investors will hesitate to invest their money in that direction.  As the anticipated net yield from that project will be very small, so they can invest money in such project only if they expect extremely favourable demand conditions.

(f)    Rate of Taxes: MEC is directly influenced by the rate of taxes levied by the government on various commodities.  When taxes are levied, the cost of commodities is increased and the revenue is lowered.  When profits are reduced, MEC will naturally be affected. It will be low, if taxes are very high and high if taxes are low.


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