Inducement to Invest’ or the investment function is the second component of Aggregate demand. Investment, according to Keynes, is the addition to real capital assets. According to classical economists investment demand was simply a decreasing function of rate of interest. Inducement to invest depends upon two factors (i) Marginal efficiency of capital and (ii) Rate of interest. Thus I = f (r, i).

The marginal efficiency of capital (MEC) is the higher rate of return over cost expected from the employment of a marginal or additional unit of capital asset. MEC means the expected rate of profitability of a new brand machine. It may be defined as the highest rate of return over cost expected from the marginal or additional unit of a capital asset. The MEC depends on two factors. (i) Prospective yield “from the capital assets, and (ii) the supply price of the capital asset. The MEC is the ratio of there two factors.

The prospective yield means the total net returns which an entrepreneur expects of obtain from selling the output of the capital asset over its life time. Running expenses are deducted from there returns. If the total expected life of a capital asset is divided into a series of years, the annual returns represented by Rp R2, R3 R, are added. The investor also takes into account the supply price of the asset it is the cost price of a new capital good. Supply price is also known as replacement cost.

The investment decisions are governed by the prospective yield aid the supply price of an asset. By comparing there two concepts we can arrive at the MEC of a particular asset. The MEC of a particular type of asset means what an investor expects to earn from an additional unit of it compared with what it costs him.

ADVERTISEMENTS:

In other words the MEC is the rate at which the prospective yield is to be discounted if it is to equal the supply price of the asset. Given the supply price, the marginal efficiency of capital is influenced by future expectations.

The low rate of interest induces investment and high rate of interest discourages it. Rate of interest, in term, is determined by the quantity of money and the liquidity preference. Given the quantity of – money the rate of interest mainly depends, on the strength of liquidity preference of two determinants MEC is the most important one to determine investment.

Investment demand curve:-

The MEC progressing declines as more and more units of that asset are produced. As more and more units of an asset are produced, they will compete against each other to meet consumers’ demand and by this the prospective yield will decline.

ADVERTISEMENTS:

With the decline in the prospective yield, the supply price of such as asset is likely to go up it more and more units of such asset are produced because of the rising cost. The decline in the prospective yield and the increase in supply price of an asset will result in lower MEC with an increased investment.

In the above diagram MEC and rate of interest are measured in the OY-axis. Along OX-axis is measured investment. The equilibrium will be established at the point where MEC becomes equal to the given current rate of interest. Thus if the rate of interest is Op then OM investment will be under taken because at OM, level of stock of capital MEC of Capital is equal to the rate of interest OP.

If the rate of interest falls to OP, investment will rise to ON since at ON level of investment the new rate of interest is equal to the marginal efficiency of capital. Thus it is seen that the curve of MEC shows the demand for investment or inducement to invest at various rates of interest. Hence MEC curve represents the investment demand curve. The Investment Demand Curve shows the amount of investment expenditure at various rates of interest.

If the investment curve (MEC curve) is less elastic, then investment demand will not increase very fetch with the fall in the rate of interest. If the investment demand curve is elastic, the changes in the rate of interest will lead to larger change in investment demand.

ADVERTISEMENTS:

When expectations regarding profit change, the whole curve of the marginal efficiency of investment will shift. It profit expectation falls or rises, the MEC curve (Investment Curve) will shift downward or upward.