John Maynard Keynes, answered from the texts and cited to the page.
The marginal efficiency of capital is the rate of discount which makes the present value of the series of prospective returns from a capital-asset exactly equal to its supply price — that is, its replacement cost, not the market price at which an existing asset changes hands.1 Two things in that definition deserve emphasis. First, the supply price I mean is not what you would pay today to acquire an asset already in existence, but the price that would just induce a manufacturer to produce a new one.2
Second, and more important, the concept is defined entirely in terms of expected yield — what the investor believes the asset will return over its life — and not in terms of what any asset has historically yielded on its original cost.3 The backward-looking calculation, however accurate as a record, tells you nothing about the inducement to invest today; that is governed wholly by prospective returns, which are a matter of expectation and not of history.
The practical consequence follows directly. Investment in any given type of capital will be pushed to the point where the marginal efficiency of that type has fallen to equal the current rate of interest — no further, because beyond that point the expected return no longer covers the cost of borrowing.4 As investment in a particular type of capital increases, its marginal efficiency falls for two reasons: the prospective yield declines as the supply of that capital grows, and the pressure on productive facilities raises its supply price.5
Both forces work in the same direction; the second tends to dominate in the short run, the first over the longer period. One confusion I am at pains to clear up: the marginal efficiency of capital is not the physical productivity of a machine in some unit of wheat or tons of steel. That formulation runs into difficulties of definition I regard as both insoluble and unnecessary, because no intelligible arithmetic ratio can be formed without bringing in values.6
Nor is it simply the current yield of capital — the return the asset is producing at this moment. An expectation that future technique will be cheaper, or that labour costs will fall, appropriately reduces the marginal efficiency of capital produced today, because the output of today's equipment will have to compete throughout its life with output produced subsequently at lower cost.7
The investor who ignores that competition is not calculating the marginal efficiency at all; he is confusing a current return with a prospective one.
I define 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.The General Theory of Employment, Interest and Money, pp. 149–152
the supply price of the capital-asset, meaning by this, not the market-price at which an asset of the type in question can actually be purchased in the market, but the price which would just induce a manufacturer newly to produce an additional unit of such assets, i.e. what is sometimes called its replacement cost.The General Theory of Employment, Interest and Money, pp. 149–152
the marginal efficiency of capital is here defined in terms of the expectation of yield and of the current supply price of the capital-asset. It depends on the rate of return expected to be obtainable on money if it were invested in a newly produced asset; not on the historical result of what an investment has yielded on its original cost if we look back on its record after its life is over.The General Theory of Employment, Interest and Money, pp. 152–153
the actual rate of current investment will be pushed to the point where there is no longer any class of capital-asset of which the marginal efficiency exceeds the current rate of interest.The General Theory of Employment, Interest and Money, pp. 152–153
the marginal efficiency of that type of capital will diminish as the investment in it is increased, partly because the prospective yield will fall as the supply of that type of capital is increased, and partly because, as a rule, pressure on the facilities for producing that type of capital will cause its supply price to increase.The General Theory of Employment, Interest and Money, pp. 152–153
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 no means of reducing this to an intelligible arithmetical ratio which does not bring in values.The General Theory of Employment, Interest and Money, pp. 153–154
the entrepreneur's profit (in terms of money) from equipment, old or new, will be reduced, if all output comes to be produced more cheaply. In so far as such developments are foreseen as probable, or even as possible, the marginal efficiency of capital produced to-day is appropriately diminished.The General Theory of Employment, Interest and Money, pp. 156–157