Alchian on Keynes


This paper examines Armen Alchian’s work on Keynes’s marginal efficiency of capital. Alchian is correct to assert that Keynes’s theory of investment based on the marginal efficiency of capital is flawed. However, Alchian does not emphasize the importance of Keynes’s error. This paper extends Alchian’s analysis to show that Keynes’s marginal efficiency of capital is a significant error.

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  1. 1.

    For examples, see Champernowne (1964, 182), Patinkin (1976, 80; 1982, 9, 78), Weintraub (1983, 618), Kahn (1984, 146), Tobin ([1987] 1990, 167), Fletcher (1987, 138), Carabelli (1988, 208), Dimand (1988, 185), Fitzgibbons (1988, 120), Skidelsky (1992, 555), O’Donnell (1997, 102), Laidler (1999, 254; 2010, 53), Backhouse and Laidler (2004, 27), Lawlor (2006, 150), Backhouse and Bateman (2011, 24), Kent (2014), and O’Donnell and Rogers (2015, 4n3).

  2. 2.

    The fact that the MEC is not identical to the RROC shows that Keynes developed the MEC independently from Fisher. Keynes used the words ‘marginal efficiency of capital’ by late 1933 ([1933] 1973, 421). The first records of his actual definition are found in the mid-1934 draft of The General Theory and his 1934 lectures ([1934] 1973, 453; [1932–35] 1988, C36, F13, H20, K17, L24, O21). However, A Treatise on Money shows that he anticipated the MEC earlier ([1930] 1971, 180). Also, anticipations of the MEC can be found in his 1932 and 1933 lectures ([1932–35] 1988, A32, B31, D16, E12, I117, J31). As will be shown, Keynes’s independent development of the MEC was not a virtue because the MEC is flawed and inferior to the NPV. On Keynes’s independent discovery of the MEC, see Schumpeter ([1954] 1994, 1144n15), Patinkin and Leith (1977, 87, 89n6), Kregel (1988, 65–66), and Kent (2014, 191). On Keynes’s anticipation of the MEC in A Treatise on Money, see Patinkin (1976, 80), Patinkin and Leith (1977, 10), Johnson and Johnson (1978, 74), Milgate (1982, 92), LeRoy (1983, 413), Dimand (1988, 184), and Meltzer (1988, 67).

  3. 3.

    Keynes is incorrect when he claims Fisher introduced the rate of return over cost in 1930. Fisher first introduced it in his 1907 work The Rate of Interest, although he called it the rate of return on sacrifice (1907, 152–56; Patinkin 1976, 80n24). Keynes’s confusion is perplexing, for he had studied Fisher’s 1907 work closely. Keynes gave a series of lectures in 1911 called Appreciation and Interest, and his lectures were “chiefly based” on The Rate of Interest (1911a). Indeed, chapter five of Fisher’s work is called “Appreciation and Interest” (1907, 77). In a 1911 review of Fisher’s The Purchasing Power of Money, he wrote that all of Fisher’s “books [are] marked … by extreme lucidity and brilliance of statement” (1911b, 394). Despite Fisher’s lucidity, Keynes missed the true relation between the rate of return on sacrifice, the rate of return over cost, and the marginal efficiency of capital.

  4. 4.

    The NPV can be traced to Fibonacci ([1202] 2002, 392) and Simon Stevin of Bruges ([1582] 1958, 107–11). But modern discounted cash flow analysis and the NPV developed out of the works of Carl Menger ([1871] 1981, 158), Alfred Marshall (1890, 516), Eugen Böhm-Bawerk ([1891] 1930, 304, 339–357; 1903, 35n1), and Frank Fetter (1904, 121; 1915, 235–313, 275n1). Irving Fisher deserves special recognition for his massive contributions to the development of the NPV (1907, 25, 140, 148–64, 175, 190, 290, 409). Although Fisher’s presentation was highly advanced by 1907, significant interest in discounted cash flow analysis did not develop until the 1950s. Unfortunately, “it was Keynes” misinterpretation which became best known” (Parker 1968, 67).

  5. 5.

    Alchian appeals to the methodology of empiricism. However, Keynes was not an empiricist and his general theory does not contain any empirical content. He was a rationalist who believed in synthetic a priori knowledge, the type of knowledge empiricism holds to be impossible. See O’Donnell (1989, 93–100) and Carabelli (2003, 214).

  6. 6.

    Friedrich Hayek also stresses the type, rather than the volume, of investment: “th[e] stock of capital is not an amorphous mass but possesses a definite structure … its composition of essentially different items is much more important than its aggregate ‘quantity’” ([1941] 2007, 34).

  7. 7.

    Hayek writes, “a fall in the rate of interest will create a tendency for the services of the most permanent factors to be invested for longer periods,” and “certain kinds of investment which were profitable at a high rate of interest will cease to be profitable at a low rate of interest” ([1941] 2007, 272, 352).

  8. 8.

    Keynes wrote that the MEC is “absolutely vital” to his theory ([1935] 1973, 549). Richard Kahn, his protégé, says, “The subject [of the MEC] is the most important one in The General Theory” (1984, 145). It follows that the MEC is an absolutely vital error and the most important error in The General Theory. Indeed, Keynes’s entire analysis of free market capitalism depends on his theory of investment: “The weakness of the inducement to invest has been at all times the key to the economic problem” ([1936] 1973, 347–48). He writes, “whether or not output is increasing depends on whether investment is increasing. Then everything is due to regulation of the problem of investment” ([1932–35] 1988, A47, G18, E9, H25, J24, K16, M18, N12, O20).


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Fuller, E.W. Alchian on Keynes. Rev Austrian Econ 33, 503–511 (2020).

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  • John Maynard Keynes
  • Armen Alchian
  • Marginal efficiency of capital
  • Net present value

JEL classification

  • E12
  • E22
  • E43
  • G31