Now we are moving away from consumption to discuss what determines the swinging investment component of aggregate income. Any capital asset can be valued in two ways: first, the supply price, which depends on the cost of actually producing the asset; second, the demand price, which depends on what entrepreneurs expect to make from using the asset. The marginal efficiency of capital is the difference between the expected yield on one more unit of a type of asset, and the cost of producing that unit. The marginal efficiency of that kind of capital whose marginal efficiency is the largest is the marginal efficiency of capital as a whole.
As investment increases, the marginal efficiency of capital falls, because the cost of producing assets rises and their yield falls as the supply of capital rises. Current investment is determined by the amount of investment that will push the marginal efficiency of capital down to the rate of interest. At equilibrium, the marginal efficiency of capital will equal the rate of interest.
Keynes makes clear that the rate of interest is independent from the marginal efficiency of capital – in contrast with (neo)classical theories that determine the rate of interest by the productivity of capital.
The yield on capital must be defined in value, not physical terms, because of the problems in defining the quantity of capital in physical terms: “It is, of course, possible to say that ten labourers will raise more wheat from a given area when they are in a position to make use of certain additional machines; but I know of no means of reducing this to an intelligible arithmetical ratio which does not bring in values.” [p. 138] This is a profound point – though Keynes does not highlight the profundity – and quite devastating to the idea of a ‘natural’ interest rate reflecting the physical productivity of ‘capital’ which somehow has some homogeneous quantity independent of its value.
Keynes quotes Marshall and Fisher to show that they sometimes use concepts very similar to his value-based concept of the marginal efficiency of capital. Marshall is even aware that it is circular to see the rate of interest as determined by the rate of return on capital, and the rate of return on capital as determined by the interest rate. But he fudges the issue elsewhere in his work.
Interestingly, in a footnote Keynes has a throwaway line: “But was [Marshall] not wrong in supposing that the marginal productivity theory of wages is equally circular?” [p. 140] Was he? I’ve mentioned a couple of times that I think it is unfortunate Keynes accepts the neoclassical theory that the real wage is equal to the marginal productivity of labour. In fact I think it does fail for the same reason as the neoclassical theory of capital. We saw in Chapter 4 that Keynes could only develop a homogeneous labour unit by assuming that the wage accurately reflected individual workers’ marginal productivity. So the quantity of labour is defined partly by real wages, and real wages are partly determined by the quantity of labour.
Keynes emphasises that it is expectations of prospective yields on an asset over the whole life of the asset, not just the current yield, that determines the marginal efficiency of capital. Eventually any long-lived asset is likely to become obsolete, producing the same commodity less efficiently than newer assets, and this probability is factored into present investment decisions. Also, anticipated inflation will stimulate investment, but only if it is anticipated.
He also emphasises that it is expectations of prospective yields that count, and because expectations are volatile, so is investment: “…it is chiefly this dependence of the marginal efficiency of a given stock of capital on changes in expectation, because it is chiefly this dependence which renders the marginal efficiency of capital subject to the somewhat violent fluctuations which are the explanation of the Trade Cycle.” [pp. 143-44] But let’s not forget that when Keynes discussed expectations in Chapter 5, it was tied up with the intersectoral relationship between producers of consumer goods and producers of investment goods, i.e., dynamic problems of balanced growth. Come to think of it, this was also at stake in Chapter 10, in the discussion of the dynamics of the multiplier: it mattered whether or not the producers of consumer goods anticipated expansion in the investment goods sector. I mention this because of theories linking the business cycle to imbalances between these sectors.
Next comes a discussion of risk: the riskiness of a venture will add to the anticipated yield required to undertake it. This is a fairly obvious point, but Keynes points out that the effect of risk may be doubled if borrowing is undertaken to pay for the project: it will be counted once in the entrepreneur’s calculations and again in the lenders’. And this is likely to accentuate cyclical movements, because “during a boom the popular estimation of the magnitude of both these risks… is apt to become unusually and imprudently low.” [p. 145] This statement is clearly influential on Minsky.
Keynes ends the chapter with a statement that it is the dynamic element that sets apart his theory of investment:
It is by reason of the existence of durable equipment that the economic future is linked to the present. It is, therefore, consonant with, and agreeable to, our broad principles of thought, that the expectation of the future should affect the present through the demand price for durable equipment. [p. 146]