UNIT – 2

Economics

2.1 NATIONAL INCOME: CONCEPT AND MEASUREMENT KEYNESIAN THEORY OF EFFECTIVE DEMAND MARGINAL PROPENSITY TO CONSUME: CONCEPT AND DETERMINATION:

Meaning:-

In ordinary language national income refers to the sum total value of goods and services produced during a year in a country. It is the aggregate money value of all final goods and services produced annually in a country.

Definition:-

According to Prof. Marshall, “The labour and capital of a country, acting upon its natural resources, produce annually a certain net aggregate of commodities, material & immaterial, including services of all kinds… This is the true net annual income or revenue of the country or the national dividend.”

According Marshall’s definition national income is arrived by adding together net output of all productive activities. The term ‘net’ implies that depreciation of machineries and plant to be deducted from Gross National Product. The net income from abroad must be added.

Features of National Income:-

1) National income is a Macro Economic concept: Macroeconomic deals with aggregate or the economy as a whole. National income data present the picture of the performance of the country’s economy as a whole in course of a given period of time.

2) National income is a flow concept: National income is the flow of goods and services produced in the country during a year. It includes only those goods or services which are actually produced.

3) National income is the money valuation of goods: National income is always expressed in monetary terms. It represents only those goods and services which are exchanged for money.

4) National income includes value of only final goods and services: In order to avoid double counting, while estimating national income, we include only value of final goods and services, and not the value of intermediate goods or raw material. For example, while estimating the production of sugar, there is no need to take the value of sugarcane, as it is already included in the price of sugar.

5) National income is the net aggregate value: National income includes net value of goods and services produced and do not include depreciation cost i.e. wear and tear of capital goods, due to their use in the process of production.

6) Net income from abroad is included in national income: While estimating national income, net income received from international trade is the net export value (X – M) as well as net receipts (R – P).

7) Financial Year: It is always expressed with reference to time period, that is, generally a financial year, which in India is from 1st April to 31st March of every year.

Circular Flow of National Income:-

The Circular Flow of National Income and expenditure refers to the process, whereby the national income and expenditure of an economy flow in a circular manner continuously through time.

Circular flow in a simple economy:-

We begin with a simple hypothetical economy, where there are only two sectors, the household and business.

• Households are the owner of factors of production and consumers of goods and services.
• Business sector produce goods and services and sell them to the household sector.
• The household sector receives income by selling the services of these factors to the business sector.
• The business sector consists of producers who produce goods and services and sell them to the household sector of consumers.
• Thus, the household sector buys the goods and services from the business sector.
• Thus, one man’s income is another man’s expenditure.

The circular flow can be understood with the help of diagram –

HOUSEHOLD              FIRM

The outer circle of diagram shows the real flow i.e. flow of factor services from household sector to business sector and corresponding flow of goods and services, from business sector to household sector.

The inner circle shows the money flow, that is, flow of factor payments from business sector to household sector and corresponding flow of consumption expenditure from household sector to business sector.

It must be noted that entire amount of money which is paid by business sector as factor payments, is paid back by the factor owners to the business sector. So here is a circular and continuous flow of money income. In the circular flow of income, production generates factor income, which is converted into expenditure. This flow of income continues as production is a continuous activity due to never ending human wants. It makes the flow of income circular.

Different Concept of National Income:-

National income refers to the monetary value of goods and services produced in a country during a year. The following are the various concepts associated with national income:

GDP, NDP, GNP and NNP are measured at market price as well as factor cost. Market price is the price paid by the consumers i.e. it is monetary value of goods and services. Factor cost refers to the prices of products and services as received by producer i.e. market price minus taxes plus subsidies. Factor cost can also be referred as the payment received by or made to the factors of production in the form of rent, wages, interest, profit, etc. Basically, the amount that is received by producers is paid to the factors of production (including the producer himself who is the entrepreneur in this case).

1)  Gross National Product (GNP): GNP is the gross market value of all final goods and services produced in a country during a year. It includes net income from abroad and depreciation. 

GNP = C+ I + G+ (X – M) + (R – P)

2)  GNP at Market price (GNPMP): GNPMP is the gross market value of final goods and services produced in the country during a year. The Market value refers to the prices prevailing in the market GNP is the basic social accounting measure for total output.                                                                                                 

GNPMP = C+ G+ (X – M) + (R – P)

3)  GNP at Factor cost (GNPFC): GNPFC is the money value of the income produced and accruing to the factors of production who were involved in producing goods and services during a year. The money received from consumers is distributed among factors of production and therefore GNPMP should be equal to GNPFC. However, government intervention in the form of indirect taxes and subsidies leads to a difference in GNPMP and GNPMP and. The effect of indirect taxes and subsidies has to be adjusted from GNPMP to arrive at GNPFC.                                         

GNPFC = GNPMP  - indirect taxes + Subsidies

4)  Gross Domestic Product at Market Price (GDPMP): GDPMP is the gross market value of final goods and services produced in the country during a year. Since, it is gross “domestic” product, the net income from abroad is not considered in its calculation.                                                                      GDPMP                            =              C+ I + G+ (X – M)              OR                                                        GDPMP                            =              GNPMP – Net income from abroad

5)  Gross Domestic Product at Factor cost (GDPFC): GDPFC is the gross market value of final goods and service produced in the country during a year. The value of indirect taxes and subsidies is adjusted from GDPMP to arrive at GDPFC

GDPFC  = C+ I + G+ (X – M) – Indirect Taxes + Subsidies OR                                            GDPFC                            =              GDPMP – Indirect taxes + Subsidies

6)  Net Domestic Product at Market Price (NDPMP): NDPMP is the net market value of goods and services produced in the country during a year. Since, it is net “domestic” product, the net income from abroad is not considered in its calculation. Further, since it is a “net” market value of goods and services, depreciation is not included while calculating NDPMP.                                                                                                  NDPMP                            =              GDPMP – Depreciation

7)  Net Domestic Product at Factor Cost (NDPFC): NDPFC is the net market value of goods and services produced in the country during a year. It is also known as “domestic income” or “domestic factor income”. The value of indirect taxes and subsidies is adjusted for GDPMP to arrive at NDPFC. Further, since it is a “net” market value of goods and service, depreciation is not included while calculating NDPFC.                                                                                                                             

NDPFC  = GDPMP – Depreciation – Indirect Taxes + Subsidies OR

NDPFC  = NDPMP – Indirect Taxes + Subsidies.

8)  Net National Product at Market Price (NNPMP): NNPMP is the net market value of goods and services produced by the residents of a country during a year. Since it is a “net” market value of goods and services, depreciation is not included while calculating NNPMP. NNPMP can be calculated by deducting depreciation from GNPMP.                                                                                                                                             NNPMP                            =              GNPMP               – Depreciation.

9)  Net National Product at Factor Cost (NNPFC): NNPFC is the net market value of goods and services produced by the resident of a country during a year. It includes income earned by factors of production.                                                                                    NNPFC                             =               NNPMP  – Indirect Taxes + Subsidies

10) National Income at Factor cost (NIFC): NIFC refers to sum of all income earned by resources suppliers for their contribution of land, labour, capital and entrepreneurial ability which are utilized in the production of the year. In short, it is the sum total of all income received and accrued to the factors of production.                            NIFC                             =              NNPMP – Indirect Taxes + subsidies                             OR                                                        NI FC                            =              NNPFC

11) Personal Income: Personal income is the sum of all incomes actually received by and accrued to all individuals or households from all the sources during a given year. Accrued income means the income which is earned but not received.

12) Personal Disposable income: Personal disposable income is the personal income which is left after the payment of direct taxes like personal income tax, property tax, etc.

Methods of National Income:-

National income refers to the total value of final goods and services produced in a year. It is also equal to the incomes of the factors of production obviously the income received is equal to income spent on goods services.

On the basis of this, there are three different approaches to calculate national income. They are –

1) Aggregate Output method      2) Aggregate Income method    

3) Aggregate Expenditure method

1) Aggregate output method:

Under this method national income is calculated by aggregating the value of all final goods and services produced in a country during a year. Whatever goods and services are produced in a country by different sectors is multiplied by their current market price. The sum total of all this obtained is actually GNP at market price. From GNP when depreciation cost is deducted we get NNP at market price.

In using this method, to avoid double counting, only the value of final goods and services should be taken into account. For this economist have suggested two alternative approaches for measuring national income by output method.

i) Final goods method  ii) Value added method

i) Final goods method: Under this method, only the value of final goods and services is taken into account to estimate GNP. The value of intermediate goods and the raw material should not be taken as it would result in double counting. For e.g. – When the value of cloth is taken, value of raw-cotton should not be included because cloth includes the value of raw-cotton.

Ii) Value added method: Under this method, we calculated the value added at each stage of production and total finally sum-up the values to get the total value of the output produced. This is explained with the help of following example:

In this table market value of final goods i.e. shirt is Rs. 100. The sum total of value added at each stage of production is also Rs. 100. Thus, GNP by value added approach is equal to the value of final goods approach. Economists consider value added method a better method and it helps to avoid double counting.

Precautions: While estimating national income by output method, the following precautions should be taken:

1)     To avoid double counting, only the value of final goods and services must be taken into account.

2)     Goods used for self consumption by farmers should be estimated by a guess work that is imputed value of goods produced for self consumption, is included in national income.

3)     Indirect taxes included in the market prices are to be deducted and subsidies given by the government to certain products should be added for accurate estimation of national income.

4)     While evaluating output, changes in the price level between different years must be taken into account.

5)     Value of exports should be added and value of imports should be deducted.

6)     Depreciation of capital assets should be deducted.

7)     Sale and purchase of second hand goods should be ignored as it is not part of current production.

2) Aggregate income method:

This method is also known as factor cost method. Under this method, national income is obtained by adding the incomes such as rent, wages, interest and profit received by all persons and enterprises in the country during a year. The total income earned by all the factors of production will be equal to the value of all type of final goods and services produced during a year.

Precautions: While estimating national income by income method, the following precautions should be taken:

1)  Transfer incomes or transfer payments like scholarships, gifts, donations, charity, old age, pensions, unemployment allowance etc., should be ignored.

2)  All unpaid services like services of housewife, teacher teaching her/his child, should be ignored.

3)  Any income from sale of second hand goods like car, house, etc., should be ignored.

4)  Income from sale of shares and bonds should be ignored, as they do not add anything to the real national income.

5)  Revenue received by the government through direct taxes, should be ignored, as it is only a transfer of income.

6)  Undistributed profits of companies, income from government property and profits from public enterprise, such as water supply, should be included.

7)  Imputed value of production kept for self consumption and imputed rent of owner occupied houses should be included.

3) Aggregate Expenditure method:

Under expenditure method the national income is viewed as the total expenditure on goods and services produced during the year. Major part of the total goods and services are consumed by households, firms and Government. The unsold goods are held by producer as stock or inventories. Hence they are assumed to be bought by the producers. The total expenditure incurred by household, Firms and Government are added up to obtain the national income.

To add up total expenditure, we include the following items:

1) Personal consumption expenditure. This is the expenditure on consumer goods and services. (C)

2) Gross domestic private investment (I). This includes the expenditure of business firms on capital goods like building, machinery, equipment etc.

3) Government purchase of goods and services. (G)

4) Net foreign investment – The expenditure on exports is added and expenditure on import is deducted. (E)                           

E = X – M + (R – P)

Now Gross national expenditure = C + I + G + E

This is called Gross national income. We can obtain Net National Income by deducting depreciation from the Gross National expenditure thus obtained.

Net National Income = Gross National Expenditure – Depreciation

Precautions: While estimating national income by Expenditure method, the following precautions should be taken:

1)  Expenditure on all intermediate goods and services should be ignored, in order to avoid double counting.

2)  Expenditure on the purchase of second hand goods should be ignored, as it is not incurred on currently produced goods.

3)  Expenditure on transfer payments like scholarships, old age pensions, unemployment allowance etc., should be ignored.

4)  Expenditure on purchase of financial assets such as shares, bonds, debentures etc., should not be included, as such transactions do not add to the flow of goods and services.

5)  Indirect taxes should be deducted.

6)  Expenditure on final goods and services should be included.

7)  Subsidies should be included.

Difficulties in measuring National Income:- The calculation of the national income of a country is a task full of difficulties and complexities. The following difficulties generally arise while estimating national income.

A] Theoretical difficulties  B] Practical difficulties

A] Theoretical difficulties:

1) Transfer payments: Monetary benefits received by persons like pensions, scholarships are personal incomes but government expenditures. Since all these are transfer payment, these cannot be included in national income. Hence this leads to under estimation of nation income.

2) Income of foreign firms: According to IMF view-point, income of a foreign firm should be included in the national income of the country, where the firm actually undertakes production work. However, profits earned by foreign firms are credited to the parent concern.

3) Unpaid services: National income is always measured in money, but there are a number of goods and services which are difficult to be assessed in terms of money. For example, painting  as a hobby by an individual, the bringing up of children by the mother, these services are not included in national income as remuneration is not given to them.                                                                                                                              Services rendered by housewives are not estimated in national income, as they are not paid for their work. A cook when employed at home is paid for his services but when the same work is done by housewife, she is not paid. Hence this leads to under estimation of national income.

4) Incomes from illegal activities: Income earned through illegal activities such as gambling, black marketing, theft, smuggling etc., is not included in national income. Such goods and services do have value and meet the needs of the consumers. Thus to that extent national income is underestimated.

5) Treatment of government sector: Government provides a number of public services like defence, public administration, law and order etc. Measuring the market value of such government services is difficult, as the real value of these services is not known; therefore it has become a convention to treat all such services as final consumption. Hence, it is included in national income.

6) Production for self- consumption: In agricultural sectors a large part of farm products are directly consumed by farmers. In the industrial sector also, cloth producers, oil producers etc. keep some products for their family. Estimates are usually taken for those products which are sold in the market. Hence absence of money value of products kept for self consumption will lead to under estimation of national income.

7) Changes in price level: National income is estimated at current market price. But because of general rise in price, national income may increase, even if national output remains constant or less.

B] Practical difficulties:

1) Possibility of double counting: To avoid double counting only the value of final goods should be taken into account. But it is very difficult to determine whether the good is intermediate or final good. For e.g. – For a restaurant, rice is an intermediate product but for a farmer rice is a final product. Because of such difficulties sometimes there is double counting and this may lead to over estimation of national income.

2) Existence of non-monetized sector: There is a large non-monetized  sector in the developing economy like India. Agriculture, still being in the nature of subsistence farming in the developing countries, a major part of the output is consumed at the farm itself and a part of production is partly exchanged for other goods and services. Such production and consumption cannot be calculated in national income.

3) Lack of occupational specialization: There is the lack of occupational specialization, which makes the calculation of national income by product method difficult. For instance, besides the crop, farmers in a developing country are engaged in supplementary occupations like dairy farming, poultry farming, cloth making etc. But income from such productive activities may not be revealed and thus is not included in the national income estimates.

4) Inadequate and unreliable data: Reliable facts and figures of personal income are generally not available. Professional does not disclose their actual income earned, salaried people may do some part time work in their spare time which they do not disclose. Inadequate & unreliable information of all this results in underestimated of nation income.

5) Capital gains or losses: Capital gains or losses, which accrue to the property owners by increases or decreases in the market value of their capital assets or changes in demand, are not included in the gross national product, because these changes do not result from current economic activities.

6) Depreciation: The calculation of depreciation on capital consumption is one more difficulty. Depreciation refers to wear and tear of capital assets, due to their use in the process of production. Depreciation of capital assets will depend on technical life of the regular and careful maintenance etc. There are no uniform, common or accepted standard rates of depreciation applicable to the various capital assets. In case of depreciation, one has to make many reasonable assumptions, which involve an element of subjectivity. So it is difficult to make correct deduction for depreciation.

7) Valuation of inventories: Raw materials, intermediate goods, semi-finished and finished products in the stock of the producers are known as inventory. All inventory changes, whether negative or positive, are included in the gross national product. Any mistake in measuring the value of inventory, will distort the value of the final production of the producer. Therefore, valuation of inventories requires careful assessment.

8) Illiteracy and Ignorance: Majority of the small producers in developing countries are illiterate and ignorant, and are not in a position to keep any account of their productive activities. So they cannot give information about the quantity or value of their output. Hence, the estimates of production and earned income simply guess.

2.4 MULTIPLIER AND ITS FUNCTIONING:

The concept of multiplier was developed by R.F. Khan in 1931. He developed it to explain the effect of an increase in investment on employment. It is known as employment multiplier.

Keynes refined it in terms of income and, hence the multiplier shows the effect of an increase in investment on income. Keynes multiplier is known as investment or income multiplier. The essence of the multiplier is that the total (direct and indirect) or ultimate increase in investment, income or employment is manifold of an initial increase in investment.

The investment multiplier is the ratio of the final change in income to the initial change in investment. Arithmetically, this relationship is expressed as

k =

Where k is the multiplier, is the increase in income and is the increase in investment. Thus, if investment increases by Rs. 100 and the income rises by Rs. 400, then the multiplier is 4. This shows that the income increases not only by the amount of original investment but by a multiple of it. Hence, the multiplier is the number by which the change in investment must be multiplied in order to determine the resulting change in total income.

The multiplier determined by the marginal propensity to consume. The relation between the MPC and the investment multiplier is shown by arithmetical formula,

It shows that the multiplier is equal to the reciprocal of one minus the marginal propensity to consume. In other words, the multiplier is the reciprocal of the marginal propensity to save, which is always equal to one minus the marginal propensity to consume.

Thus,           

For example, if the MPC is 9/10 the MPS is 1/10, and the multiplier is 10. If MPC is 4/5, the MPS is 1/5, and the multiplier is 5.

The size of the multiplier varies directly with the size of the MPC. If the MPC is high the multiplier is also high, and when the MPC is low the multiplier is also low. The value of multiplier can never be one because MPC is never zero but greater than zero. The multiplier can never be equal to infinity because MPC is never one nut less than one. In other words since the marginal propensity to consume is greater than zero but less than one, the multiplier is always greater than one but less than infinity, that is,

Working of the multiplier:

The multiplier explains the cumulative effect of a change in investment on income via its effect on consumption expenditure. It is the mechanism through which income gets propagated as a result of original investment. This is explained by the following arithmetical example. Let us suppose that MPC is 4/5 and, therefore the multiplier is 5. Then an increase in investment of Rs. 1000 will increase the total income by Rs. 5000. The process of income generation from the original investment is explained in table 8.1.

Table 8.1: The effect of Increased Investment on Income,

Consumption and saving

Original Increase in Investment	Induced Increase in Income	Additional Consumption from Increased Income  4/5	Saving Out of Income (Rs.)
1000	1000 800 640 512 409.60 Etc.	800 640 512 409.60 327.68 Etc.	200 160 128 102.40 81.92 Etc.
Total Rs. 1000	Rs. 5000	Rs. 4000	Rs. 1000

It can be seen from the table 8.1 that an investment of Rs. 1000 increases the income by Rs. 1000 of the people whose factors of production get employed as a result of new investment. Since MPC is 4/5, the income recipients spend Rs. 800 on consumption. Thus, in the second round income will increase by Rs. 800 because one person’s expenditure is another person’s income. Out of 800, 80 percent will again be spent on consumption and, therefore, income will increase by Rs. 640 in the third round, by Rs. 512 in the fourth, by Rs. 409.60 in the fifth and so on till the income has increased to Rs. 5000.

Thus there is an infinite geometric series of the descending variety, viz, Rs. 1000 + Rs. 800 + Rs. 640 + Rs. 512 ……. So on. The formula for an infinite geometric progression is where MPC which is less than one. Thus, the simple multiplier formula is

Change in income  = change in investment

= change in investment

Thus, it follows from our example that

Change in income  =  

= 5 x 1000 = Rs. 5,000

The multiplier effects of an increase in investment on income is shown diagrammatically in figure

The C curve is the consumption curve and it is drawn on the assumption that MPC is constant at all levels of income.* When we superimpose a fixed amount of investment on the consumption curve C we get total expenditure curve C + I. It intersects the 450 line at point E and, therefore, the original.

* According to keynes the value of MPC, is likely to fall as income increases. However the principle of multiplier will be the same. The only difference is that the calculations will become more complicated because, for each period increment, we have to use a smaller multiplier, since the MPC diminishes as income increases. Equilibrium level of income is Y. When investment rises, the total expenditure curve shifts upwards to C + I + I1. The increase in investment is equal to the vertical distance between the two total expenditure curves and it is equal to AE. The new expenditure Curve C + I + I1 intersect the 450 line at E1 and, therefore, the original income YY1. It can be seen from the Figure 8.1 that the increase in income (Y) is a multiplier of the increase in investment (I), that is, YY1 > AE.

2.5 INVESTMENT: FUNCTIONS AND ITS CONCEPTS :

Investment is determined principally by the marginal efficiency of capital and the rate of interest. The marginal efficiency of capital is ordinary called the expected rate of profit. The prospective investors will keep on comparing the marginal efficiency of capital with the rate of interest. If investment is to be profitable the expected rate of profit must not be less than the current rate of interest in the market. If the expected rate of profit greater than the rate of interest there will be new investment. Conversely, there will be no investment if the rate of interest is higher than the marginal efficiency of capital.

The rate of interest is relatively “sticky” that is it does not change much in the short run. Thus, the inducement to invest primarily depends upon the marginal efficiency of capital. Changes in the marginal efficiency of capital cause changes in investment which in turn causes fluctuations in aggregate demand.

Since the marginal efficiency of capital plays a very important role in the determination of investment, we explained below in detail the concept of marginal efficiency of capital.

Marginal Efficiency of Capital:

The marginal efficiency of capital (MEC) refers to the expected rate or profit from an investment in a new capital asset. It is the highest expected rate of return over cost from an additional unit of capital asset. The MEC depends upon two factors, viz.

1)     The expected rate of return [or the prospective yields] of a capital asset over its life time, and

2)     The supply price or replacement cost of the capital asset.

The prospective yield refers to the total net return expected from the capital asset over its life time. The supply price of the capital asset refers to the cost of the new asset which is called the replacement cost. The MEC is the ratio of these two elements, that is the prospective yields and the supply price.

Keynes has defined “the marginal efficiency of capital as being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital – asset during its life just equal to its supply price”. Thus, according to Keynes, MEC is the rate of discount which would make the present value of the prospective yields from a capital asset equal to its supply price. This definition of MEC is expressed as:

Supply Price = Discounted Prospective Yields

The above definition of MEC can be expressed in terms of the following equation and we can thus find the value of MEC from it. Thus,

Where C is the supply price of the capital assets, R1, R2, R3 …… Rn are the annual prospective yields from the capital assets, and r is the rate of discount or the marginal efficiency of capital. In other words, r is the internal rate of return on that asset.*

The meaning of the MEC as a rate of discount is illustrated by the following arithmetical example. Let us suppose that the supply price or cost of the capital asset is Rs. 3000 and the life of the asset is 2 years, that is, it will not have any economic value after two years. It is expected to yield an income of Rs. 1100 in the first year and Rs. 2420 in the second year. By substituting these values in the above formula we can calculate the value of r, that is the marginal efficiency of capital. Thus,

C =

3000 =

Therefore, r = 10%

In other words, the marginal efficiency of capital is 10 percent. If we put the value of r, that is, 10%, in the above equation, it will equate the sum of the discounted prospective yields to the current supply price of the capital asset. Thus,

3000 =

= = 1000 + 2000 = 3000

The follows from the above that the marginal efficiency of capital varies with the changes in prospective yields and the supply price of the capital asset. Given the supply price, a fall in the prospective yields will lower the MEC and vice versa. Similarly, given the prospective yield, MEC will fall with the increase in the supply price of the capital asset and vice versa.

As investment in a particular capital asset increases the marginal efficiency of that capital falls, partly because the prospective yield falls as the supply of that capital is increased, and partly because the supply price of the capital asset increases on account of pressures on the facilities for producing. That type of capital asset*. Thus, MEC falls as investment increases due to fall in the prospective yield and rise in the supply price of the capital asset. The marginal efficiencies of all types of capital assets which may be made during a given period of time represent the schedule of the MEC, or the investment demand schedule. A hypothetical MEC schedule is given in Table

Table : MEC Schedule

The Table shows that as investment increase in a particular capital asset the MEC goes on falling. The behavior of MEC schedule is explained by MEC curve in Figure 7.1.

The MEC curve is downward sloping. It shows the inverse relationship between investment and MEC, that is as investment increases MEC declines.

Determination of Equilibrium Level of Investment by MEC and Rate of Interest:

We have seen that the volume of investment is determined by MEC and the rate of interest. As long as MEC is higher than the rate of interest investment will be continued to be made. The equilibrium level of investment will be established at the point where MEC becomes equal to the current rate of interest. If the rate of interest is lower than the MEC, the market value of the expected prospective yields from a capital asset will be higher. Thus, Keynes makes a distribution between the demand price and supply price of a capital asset. The demand price of a capital asset is equal to the sum of the expected prospective yields discounted at the current rate of interest. It is expressed in terms of the following equation:

Demand Price =

Where i is the the rate of interest. Using our earlier example we can find that, at 5 percent rate of interest, the demand price of the capital asset which promises to yield Rs. 1100 in the 1st year and Rs. 2420 in the second year will be greater than Rs. 3000/- Thus.

Demand Price  =

=  1047.62 + 2195 .01

= Rs. 3242.63

The demand price of an asset is its true present value, what it is worth in the market. The demand price and the supply price of the asset are determined respectively, as given below:

Demand Price  = Sum of prospective yields discounted at the rate of interest.

Supply Price   = Sum of prospective yield discounted by the

Marginal efficiency of capital

When the supply price is less that the demand price the MEC will exceed the rate of interest and, therefore investment will increase because new investment in capital assets will be profitable. Conversely when the supply price is greater than the demand price MEC will be lower than the rate of interest and, therefore investment will fall. When the supply price is equal to demand price, MEC will be equal t the rate of interest and, therefore, investment will neither increase nor decrease. Thus, investment will be in equilibrium when MEC becomes equal to the given current rate of interest.

Equilibrium level of investment is reached when marginal efficiency of capital (MEC)and rate of interest are equal. As we discussed earlier MEC shows the rate of profit and interest is the cost of capital.

Table 7.2 explains the equilibrium investment.

Table 7.2

At Rs. 75,000 million investment, the MEC and rate of interest (R) are equal making it equilibrium level of investment. Prior to this MEC > R and beyond that R > MEC. Investors are encouraged to invest till they reach equilibrium point and will not invest beyond that as cost (R) is greater than the expected rate of profit (MEC).