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Explain the term Marginal Efficiency of Capital (MEC) - Leaving Cert Economics - Question b - 2017
Question b
Explain the term Marginal Efficiency of Capital (MEC). Outline two possible reasons for a fall in MEC.
Worked Solution & Example Answer:Explain the term Marginal Efficiency of Capital (MEC) - Leaving Cert Economics - Question b - 2017
Step 1
Explain the term Marginal Efficiency of Capital (MEC)
Answer
The Marginal Efficiency of Capital (MEC) is defined as the additional profit generated from the employment of one extra unit of capital. It assesses the potential return on investment as capital is added, highlighting how effective capital flows contribute to profitability.
MEC is generally considered in the context of investment decisions, where a higher MEC indicates a more lucrative opportunity. It reflects the relationship between the cost of capital and the expected return, emphasizing that capital should only be employed if the MEC exceeds the cost of that capital.
Step 2
Outline two possible reasons for a fall in MEC
Answer
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Cost of capital increases / Rate of interest increases: An increase in the cost of capital or the interest rate means that investments are less profitable. As borrowing becomes more expensive, the MEC decreases, leading to a reduced incentive to invest.
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Fall in productivity of the extra capital being used: Over time, as more capital is employed, the returns from that additional capital may diminish due to factors such as diminishing marginal returns. As productivity per unit of capital declines, MEC will also fall, making it less attractive to continue such investments.