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KEYNES' MARGINAL EFFICIENCY OF CAPITAL: A JUSTIFICATION OF MARX'S TENDENCY FOR PROFITS TO FALL?

There is no denying that John Maynard Keynes is the most credited figure in subduing the Great Depression. The event, in addition to highlighting Keynes' name, also shocked classical economists and their supporters. Starting from his open letter to President FD Roosevelt, Keynes then became more famous thanks to his thoughts contained in the General Theory, although he had expressed his thoughts in a number of previous works. In fact, his modern economic theories, which revolutionized previous economic theories, are the basis of economic books today.


Keynes' contribution to the resolution of the Great Depression was so great that it was impossible for people in the world of economics not to think of Keynes' name after hearing the term Great Depression. In his writings, Keynes mentioned the term marginal efficiency of capital as a result of the economic crisis. In short, Keynes said that when investment in production machinery continues to increase, at a certain point, additional investment actually causes a decline in profits. However, similar thoughts have actually been expressed by the economist who became the main actor in Marxian economics, namely Karl Marx.


Karl Marx, an influential economic thinker, formulated his critique of capitalism against the backdrop of a society marked by the coexistence of capitalism and feudalism. One of Marx's enduring theories, the law of the tendency of the rate of profit to fall, remains a topic of debate, even among his followers. This law suggests that capitalism continues to expand to an irrational point, where the factor of production shifts from labor to machines. It states that profits will decline as the position of labor shifts to machines. Marx's theory, which is widely debated, was in line with what happened in the Great Depression, which Keynes expressed as a condition of decreasing the marginal efficiency of capital. This article is designed to analyze these two theories, and conclude whether Keynes implicitly justified Marx's theory.


Marginal Efficiency of Capital


Marginal efficiency of capital (MEC) is not purely Keynesian thinking, but was initiated by Irving Fisher. Keynes then included this theory in General Theory for further analysis (Kregel, 1988). In his theory of effective demand, Keynes stated that investment is the most volatile component. By investing, it means there is a return that the entrepreneur hopes for. In detail, Keynes (1936, as cited in Tsoulfidis, 2008) defined MEC as follows:


"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 expected returns from the capital asset during its life just equal to its supply price."

Thus, MEC is based on expectations of future returns. In simple terms, MEC is the ratio between investment returns, or prospective yield, and the price of the asset when invested.


Keynes stated that if there is an increase in investment in a type of capital in a certain period, the MEC of that capital will specifically decrease. This is caused by two factors. The first is that as the supply of capital increases, the prospective yield, or income from investment, decreases. Keynes said that the prospective yield on an asset is only obtained when the asset is scarce. The second factor is that the presence of 'pressure' will cause capital producers to raise prices. As long as the company increases its capital investment, it will be very difficult for the company to maintain its sales growth. The way a company can do this is by reducing the price of its products. However, this means that company profits will fall (Tsoulfidis, 2008). In addition, the higher capital price increases the cost of investment projects which causes MEC to decrease. In the expansion phase, when income and output increase, the demand for money increases so that interest rates also increase. This increase makes some potential projects unprofitable. Thus, a fall in the MEC, coupled with a rise in interest rates, causes investment to decline.


Keynes argued that the level of output and employment depended on demand, where demand was based on the level of investment. We already know that MEC is the ratio between prospective yield and capital price. Prospective yield, according to Keynes, is influenced by future uncertainty (Ellsworth, 1936). A decrease in MEC below the interest rate means that companies should choose to save rather than invest. Keynes claimed that savings can exceed investment, and this will cause a lack of aggregate demand for goods and services, or what Keynes called effective demand. To overcome this, Keynes stated that the government must expand by reducing taxes and increasing spending so that individuals can use more of their money. However, this may not work because in uncertain conditions, people will choose to save rather than spend. In other words, government spending is not a guarantee of increasing the confidence of economic actors. The same thing can also happen if interest rates are increased. In uncertain conditions, there is a high possibility of a liquidity trap occurring. The interesting thing is that this shows the weaknesses of the capitalist system.


The pessimism that emerged caused share prices to fall and as a result, MEC declined further. Keynes revealed that the cause of the Great Depression was not an increase in interest rates, but a decrease in MEC and pessimism that spread in the economy (Tsoulfidis, 2008). Keynes also thought that MEC was not related to interest rates (Kregel, 1988). When pessimism develops, whatever interest rate is set, it will not – and even if it has an effect, the effect is small – change investors' expectations, thereby creating a liquidity trap.


Marx's Law of Tendency of the Rate of Profit to Fall vs. Marginal Efficiency of Capital


Karl Marx, an economist whose ideas have generated both acclaim and criticism, built his theories upon a foundation of critique aimed at the prevailing system of capitalism, which continues to hold significant influence to this day. There are many theories that Marx conveyed regarding capitalism, but there are ideas that are still debated to this day. This idea is the law of the tendency for profits to fall or the law of tendency of the rate of profits to fall.


Marx stated that capitalist development would lead to a tendency for companies to replace labor with machines. For Marx, it is labor that can create new value in finished goods. Meanwhile, surplus value is crucial for capitalists because it is the basis of company profits (Christiansen, 1976). The smaller the labor input in the production process, the smaller the surplus value. As a result, profits decrease. When shifts continue to occur, conditions will lead to an economic crisis.


In detail, Marx's law of decreasing profit tendencies is based on the labor theory of value which was originally created by Adam Smith and David Ricardo. The theory basically says that only labor creates value. According to Dickinson (1957), Marx symbolized labor by v variable and surplus value by s. In one working day, v is the hours worked by the workforce, while the rest is the source of profit, s. The ratio of these two variables Marx calls the level of surplus value, i.e


s'=s/v


and Marx defines profit as


r'=s/(c+v)


where c is constant capital, for example machines. Marx called it constant because its value does not change.


The law of tendency of the rate of profit to fall forms the cornerstone of Marx's crisis theory. According to Marx, as competition among capitalists intensifies, the surplus value generated will no longer be sufficient to cover a company's expenses. To survive in this fiercely competitive landscape, companies begin to replace labor with machinery. At this stage, the composition of a day's work includes labor (v), machinery or capital (c), and surplus (s). Moreover, as companies invest more in machinery, the ratio between c (capital invested in machinery) and v (wages for labor) increases. Marx referred to this as the organic composition, signifying a higher proportion of machinery to labor.


If the profit formula is divided by then we will get


(s/v)/(c/v)+1


so that when the organic composition increases and the increase is faster than the increase in the surplus level, the profit equation above will decrease. According to Marx, the only way that capitalists can overcome this is by increasing v, which means the use of machines is reduced. It should be emphasized that apart from technological improvements, the decline in organic composition was also caused by a decrease in wages (Christiansen, 1976). Therefore, by increasing the number of workers c/v

decreases so that profits can be restored. However, if what happens is that investment continues so that profits continue to decline, this will lead to a crisis.


Marx's theory is similar to Keynes' MEC theory that at a certain point, an increase in capital investment will cause a decrease in profits. Both also agree that investment is a determinant of output and employment. In the previous description, it was stated that the prospective yield will be greater if capital is scarce. This, implicitly, shows that for Keynes, to overcome the decline in MEC, labor must be increased, while capital is reduced.


This means that Keynes's theory is in line with Marx's theory. However, the details need to be kept in mind. Keynes indeed revealed that the crisis, namely the Great Depression, was caused by conditions when additional investment no longer increased profits. However, the emphasis he gives is on investments that influence effective demand.

Meanwhile, Marx, in accordance with the name of his law, argued that crisis caused by a decrease in profits due to excessive investment in capital so that entrepreneurs eventually fall. Marx's emphasis was on profit. As more and more machines are used, profits, which come from the value of labor, decrease, which at some point can lead to an economic crisis. Keynes's emphasis on the demand side does not appear to be directly related to corporate profits.


Although Marx's law of decreasing profits continues to be debated, it is important to emphasize that this theory was created in the 19th century, at which time capitalism was everywhere. The main focus of capitalists is of course profit. Adam Smith and David Ricardo also doubted that capitalism had weaknesses – and were proven right. Therefore, Marx, who based his thinking on criticism of capitalism, focused his crisis theory on profit.


The interesting thing is that in the law of tendency of the rate of profit to fall, the crisis caused by the decline in profit is said by Marx to be the end of capitalism. This really happened when the Great Depression, in which the economic system was free from government hands, finally collapsed. Unfortunately, Marx's law, although in simple terms the same as Keynes's MEC theory, contradicts reality. Once again, the Great Depression occurred due to a shock on the demand side caused by investment, as Keynes said. On the other hand, Marx emphasized profit, which can implicitly be interpreted as meaning that Marx's crisis theory originates from the supply side.


Conclusion


The validity of Marx's law of decreasing profit tendencies is still debated. Marx's supporters tried to justify this theory, but the opponents always seemed to have a strong argument that this law was not the cause of the crisis, as Marx claimed. If interpreted from the surface, namely "excessive investment in capital leads to crisis",

indeed, Keynes's marginal efficiency of capital and Marx's law of tendency of the rate of profit to fall can be justified on the basis of the Great Depression. However, these two theories have different meanings if dug deeper. Keynes's theory, although basically similar to Marx's ideas, when interpreted as the cause of the crisis, the two have differences. Marx emphasized that the decline in profits due to excessive investment in machines ultimately caused a crisis, while Keynes emphasized that excess investment in machines ultimately reduced profits, but the cause of the crisis was from the demand side which was influenced by the investment itself. Thus, it can be concluded that if limited to theory alone, Keynes agrees with Marx, although with a different analysis. However, if the comparison is extended to the causes of the crisis, it would be wrong to assume that Keynes confirmed Marx's law of decreasing profits.



References

Christiansen, J. (1976). Marx and the Falling Rate of Profit. American Economics Review, 66(2): 20–26.

Dickinson, H. D. (1957). The Falling Rate of Profit in Marxian Economics. Review of Economic Studies, 24(2): 120–130.

Ellsworth, P. T. (1936). Mr Keynes on the Rate of Interest and the Marginal Efficiency of Capital. Journal of Political Economy, 44(6): 767–790.

Heinrich, M. (2013). Crisis Theory, the Law of the Tendency of the Profit Rate to Fall, and Marx's Studies in the 1870s. Monthly Review, 64(11). https://doi.org/10.14452/ MR-064-11-2013-04

Kregel, J. (1988). Irving Fisher, Great-Grandparent of the “General Theory”: Money, Rate of Return over Cost and Efficiency of Capital. Papers in Political Economy, (14): 59–68.

Tsoulfidis, L. (2008). Keynes on the Marginal Efficiency of Capital and the Great Depression. History of Economic Ideas, (16)3: 65–78.






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