The

VOL. 17 | NO. 4 | 519–524

Quarterly
Journal of
Austrian
Economics

WINTER 2014

The Marginal Efficiency of Capital:
A Comment
Lucas M. Engelhardt
ABSTRACT: The impact of interest rates on investment choices is a key element in both Keynesian and Austrian theories of the business cycle.
Fuller (2013) compares the Keynesian Marginal Efficiency of Capital approach to the Austrian Net Present Value approach, claiming that the two give different rankings of investment projects. This comment provides examples to show that this is only true if factor prices are held constant. If factor prices reflect the discounted present value of the project, then the different rankings between the approaches vanishes. This result further highlights a fundamental difference between the Austrian and Keynesian views: factor price stickiness. This difference in assumptions drives the opposing views of monetary policy.
KEYWORDS: John Maynard Keynes, marginal efficiency of capital, net present value, interest rates, central banking
JEL CLASSIFICATION: E12, E22, E52, E58

I

n his recent article, Edward W. Fuller (2013) compared the
Keynesian Marginal Efficiency of Capital approach with the
Austrian Net Present Value approach. While his article has some important insights regarding the different treatments of investment
Lucas Engelhardt (lengelha@kent.edu) is Assistant Professor, Department of
Economics, Kent State University at Stark.
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The Quarterly Journal of Austrian Economics 17, No. 4 (2014)

projects in these two approaches, the result that the two approaches result in different rankings will only hold if factor prices are held constant. But, as the paper states, such an assumption is generally not true.
To briefly summarize Fuller’s main point: the net present value criterion demonstrates that there is a “switching” from one type of investment project to another as interest rates change. In particular, as interest rates rise, shorter projects will be preferred, while longer projects are preferred when interest rates are lower.
In the marginal efficiency of capital approach, there is no such switching. Rather, there is an invariant list of projects with each listed by its rate of return (defined as that interest rate which sets the net present value equal to zero), and the going interest rate acts as a “hurdle” rate, determining how far down the list investors will go when funding projects.
All of this is true, if we hold the cost of starting the projects (and therefore the rate of return) constant. However, if we include the insight that “[c]ompetition between investors creates a tendency for the net present value of an investment project to equal zero”
(Fuller, 2013, p. 381), then these results fail to hold. To show this, I will slightly modify Fuller’s examples.
Suppose that we have two projects that would utilize the same resources, so entrepreneurs with these two projects in mind are bidding against one another. The first project (“Project 1”) pays $1,000 of positive cash flow in each of the next three years
(equivalent to Fuller’s “wooden bridge”) The second project
(“Project 2”) pays $1,000 for each of 8 years, starting 3 years from now (equivalent to Fuller’s “steel bridge”). Fuller assumes that the first project will cost $2,000 to start, while the second costs $5,000.
That is where the problem lies: if competitive bidding occurs, then the starting cost is not fixed. It will depend on the interest rate, and the Net Present Value (NPV) of the project with greater present value will be zero, while the less valuable project’s NPV will be negative. In short: while it is true that, “other things equal”, as the interest rate changes, the NPV will change as described by Fuller,
Fuller has argued that when the interest rate changes, the startup cost of the project will change as well—and will change to keep the
NPV at zero for any projects that get funded. To reexamine Fuller’s point, we calculate the Present Values (not the Net