Nafziger Economic Development (4th ed)

376Part Three. Factors of Growth

70 percent (Intel, Canon, Fujitsu, Ankor, Olympus Optical), Malaysia 57 percent (semiconductors, robotics, advanced electronics, medical equipment, optoelectronics, software engineering, biotechnology, aerospace), Costa Rica (Intel, Lucent, Hitachi, and Panasonic) 36 percent, Thailand 31 percent, Mexico 22 percent, China 20 percent, and Brazil 18 percent (World Bank 2003h:302–305). How much does dependence on foreign investment and outsourcing hamper the potential of the growth of high-tech exports in the future? Anthony P. D’Costa (2003a:51–82) contends that India’s software services’ export dependence on a single market, the United States, contributes to a lower trajectory for innovation, with few domestic backward or forward (user feedback) linkages. India’s concentration of skills is not in programming, design, and systems but in software services and low-tech ICTenabled services, with minimal scope for climbing the ladder to complex high-value projects.

However, some Asian manufacturers use ICT at the forefront of sales and marketing innovation. The Wall Street Journal (Kahn 2003:A1) reports how J. C. Penney slashed shirt inventory from six months to virtually zero by outsourcing inventory management to a Hong Kong shirtmaker, TAL Apparel Ltd. Harry Lee, TAL’s managing director, with a U.S. Ph.D. in electrical engineering, hired programmers, “who designed a computer model to estimate an ideal inventory of house-brand shirts for each of Penney’s 1,040 North American stores, by style, color and size.” TAL collects point-of-sale information directly from Penney’s stores, runs the data through its computer model, and “decides how many shirts to make, and in what styles, colors and sizes.” Sending the shirts directly to each Penney’s store bypasses warehouses and corporate decision makers. At times, TAL sends shirts to stores by air freight to keep its customer happy. In 2003, TAL, which made one in eight dress shirts sold in the United States, “supplied labels such as J. Crew, Calvin Klein, Banana Republic, Tommy Hilfiger, Liz Claiborne, Ralph Lauren and Brooks Brothers.” More North American retailers are depending on suppliers that can respond swiftly to changing demands.

In the late 1990s, although the Somalian state had collapsed, the growth in telecommunications facilities, including expensive satellite telephones, expanded rapidly. Herders and border traders, who had little access to formal banking institutions, and the Somali diaspora in the West and the Middle East, used Internet, fax, and telephone services to transfer remittances home. This informal hawala (“transfer” in Arabic) avoided the need to carry large amounts of cash. In 2001–03, much of this system, tainted by accusations of terrorist links, was shut down by pressure from the U.S. government (Little 2003:138–144).

Some ICT innovations are on a smaller scale. Remember Bangladesh’s Grameen Bank, discussed in Chapter 6. A subsidiary of the bank, Grameen Telecom operates village pay phones that lease cellular telephones to rural women and other bank members, who use the phone to provide services and earn money. These phones lower the cost of information gathering, contributing to “lower prices for poultry feed, more stable diesel prices, and less spoilage of perishable goods due to more

precise shipment dates. . . . Telephone users include both rich and poor, but poor people make more calls for economic reasons” (World Bank 2001f:73).

Cellular phone technology gives Bangladesh women more bargaining power. Halima Khatuun, a poor, illiterate woman who sells eggs indicated

I always sell eggs to middlemen. In the past, whatever prices they offered, I accepted because I had no idea about the going prices of eggs. . . . Last week, the middleman came and desired to pay me 12 taka per hali [four units] . . . Keeping him waiting, I rushed to check the prices through the Village Phone. The price was 14 taka per hali of eggs in nearby markets. I came back and refused to sell to him at the lower prices. . . . After a brief haggling, we agreed to buy and sell at 13 taka per hali.” (World Bank 2001f:73)

Artisans in the Middle East and North Africa have long crafted high-quality products using traditional techniques. But local markets, an important source of income for poor people, are shrinking. Gaining access to lucrative national and international markets is difficult. The Virtual Souk, an internet-based marketplace, now provides direct access to world markets for hundreds of artisans from Egypt, Lebanon, Morocco, and Tunisia, many of whom are women. Since 1999, online sales have soared exponentially, reaching DC markets and increasing proceeds substantially (ibid.).

In Sri Lanka, according to the World Bank (2001f:87), rural telephone service increased farmers’ share of the price of crops from 50–60 to 80–90 percent (World Bank 2001b:87).

Bangladesh cellular phone technology and the Middle Eastern Virtual Souk have empowered artisans and petty traders, indicating that some LDC poor are reducing the digital divide. Moreover, the Internet, with its low entry barriers, is providing alternative sources of information, overcoming the restrictions of the national and international press, radio, and television (U.N. Development Program 2002a:77).11 Better communication increases the incomes and information of poor and middleclass people.

An increasing portion of a modern information-oriented economy is weightless, shortening the “distance” between consumers and producers of knowledge products. Commodities (computer software, telecommunications, semiconductors, algorithms, financial services, databases, libraries, media entertainment, and Internet delivery) retain their value independent of their physical manifestation. The growth model assumes a system of intellectual property rights, in which the researcher obtains a patent for a useful idea and uses the patent, or sells it to a firm producing an intermediate good (Pohjola 2001:1–5; Quah 2001:93).

11Sugata Mitra, NIIT, New Delhi, India, installed a computer with high-speed Internet connection in a hole in the wall in a slum next to their office, leaving it open for anyone to use. The slum children, many without primary education, downloaded music, and opened games, Disney sites, and sites with current events and cricket news. The experiment was replicated in at least 100 locations in India (Aggarwal 2002).

378 Part Three. Factors of Growth

Investment Criteria

Investable resources can be used in a number of ways: to build steel mills or fertilizer plants, to construct schools, to buy computers, to expand applied research, to train agricultural extension agents, and so on. And because there are not enough resources to go around, we must choose among investments. The rest of this chapter indicates how we can make these choices in an economically rational way.

MAXIMUM LABOR ABSORPTION

In LDCs, labor – often underemployed and having low alternative costs – is usually considered the abundant factor, and capital, the scarce factor. Thus, we might expect LDCs to specialize in labor-intensive goods (that is, those with high labor– capital ratios). Specifically, this means that LDCs should replace the capital-intensive industrial techniques common in DCs with more labor-intensive approaches.

As discussed in Chapter 10, appropriate technology for LDCs should fit their factor proportions. According to E. F. Schumacher (1965:91–96), the advocate of small is beautiful (Chapter 2), an intermediate technology is needed – techniques somewhere between Western capital-intensive processes and the LDCs’ traditional instruments. In practice, however, many LDCs use capital-intensive methods. Sometimes, entrepreneurs, bound in inertia, may not question existing capital-intensive designs. But these techniques have other attractions in LDCs as well.

1.Businesspeople often want to use the most advanced design without knowing that it may not be the most profitable. James Pickett, D. J. C. Forsyth, and N. S. McBain (1974:47–54), on the basis of field research in Africa, attribute this attitude to an engineering mentality.

Engineers . . . are professionally driven by . . . the half-artistic joy in technically perfecting the productive apparatus. . . . The engineer’s interest is in technical efficiency – in extracting the maximum amount of sucrose from a given input of sugar cane; and from this standpoint machines are often more reliable than men. . . . A decision is taken, for example, to establish a plant of some given productive capacity in a developing country. Engineers trained according to developed country curricula are asked to design the plant. They produce blueprints for a limited number of alternatives, each of which is a variant on current “bestpractice” technique. The alternatives are submitted to economic . . . scrutiny, the most attractive chosen, and another capital-intensive, technologically inappropriate plant is established.12

2.For many commodities, there may be no substitute for a highly capital-intensive production process, as the ratio of capital to labor is unalterable (Chapter 10). With fixed factor proportions, a given amount of capital may not fully employ

12The economist rejects the technically most efficient process where less costly inputs or improved revenue prospects increase social profitability. Economic efficiency implies that the use of a resource should be expanded when the extra social revenue associated with it exceeds the extra social cost, and contracted when the reverse occurs, even if this implies substituting crude labor-intensive machines for the “bestpractice” sucrose-extracting machines.

the labor force. Yet, there may be no other technologies available using higher ratios of labor to capital to produce the specified commodities.

3.Capital-intensive methods embodying technical advances may be cheaper per output unit than either traditional labor-intensive approaches or newly designed intermediate technologies. Businesspeople may find that modifying existing technologies is more expensive than using them without alteration. For, as Chapter 12 indicates, adapting existing Western technology to LDC conditions often requires substantial (and sometimes costly) creativity.

4.Automatic machinery may reduce the need for skilled workers, managers, or administrators, all of whom are scarce in developing countries. Conserving on expensive personnel may be as important as conserving capital in LDCs (see Chapter 10).

5.Although LDC labor is abundant and its wage is lower than in DCs, it is not necessarily cheaper to hire because its productivity may be lower. The efficiency wage (the wage rate divided by the productivity of labor) and wage costs per unit of output may differ little between LDCs and DCs (Thirlwall 1995:233–234).

6.Factor-price distortions may make capital, especially from abroad, cheaper than its equilibrium price. The reasons for these distortions, as indicated in Chapter 9, include minimum-wage legislation, pressure from organized labor, subsidies to capital, and artificially low foreign exchange prices.

Thus, maximizing a project’s labor intensity is not a sound investment criterion. Nevertheless, LDC planners need to examine carefully technologies in which labor can be substituted for capital.

Yet most of the global stock of new technology is capital intensive. Buddhadeb Ghosh and Chiranjib Neogi (1993:308–325) recommend that a country acquire new technology even if capital intensive but modify through local R&D until it discovers the appropriate technology.

SOCIAL BENEFIT–COST ANALYSIS

Suppose society has a given amount of resources to invest to raise output. The objective is to allocate these limited resources to achieve the largest possible increase in the economy’s capacity to produce goods and services. A standard approach, social benefit–cost analysis, more comprehensive than the just-discussed labor absorption criterion, states that you maximize the net social income (social benefits minus social costs) associated with a dollar of investment.

The net present value (V) of the stream of benefits and costs is calculated as

where B is social benefits, C is social costs, r is the social discount rate (the interest rate set by planners), t is time, and T is the life of the investment project.

Interest on capital reflects a discount of future income relative to present income, because more capital invested now means society produces a higher income in the

380 Part Three. Factors of Growth

TABLE 11-2. Present Value of Hypothetical 20-Year Net Income Streams from Two Alternative $1 Million Investment Projects in Year 0 Discounted at 15 Percent per Year

Even though the summation of undiscounted net incomes is higher for the textile factory than the sugar refinery, planners should invest in the refinery, because its present value is higher. The example illustrates the importance of higher net incomes in the first few years before the discount factor is very high.

future. Thus, even where there is no risk or inflation, a dollar’s worth of future income is never worth so much as today’s dollar. Future values are always discounted, and the more distant the payoff, the greater the discount.

Suppose an irrigation project results in a net stream of $200 per year for 20 years, but nothing thereafter. The total net income stream is 200 × 20 = $4000 over the investment life. Assume, however, that the discount rate is 15 percent. This discounts the $200 annual net return to $173.91 in the 1st year, $99.43 in the 5th year, $49.44 in the 10th year, $24.58 in the 15th year, and $12.22 in the 20th year. The discounted

value of the total income stream over the 20-year period is not $4,000 but only $1,251.87.

Now to return to decisions about investment, you should rank investment projects by their V (Table 11-2 shows how to rank two hypothetical investment projects by V). Choose projects with the highest ratio of V to K (the amount of capital to be allocated), then the next highest V/K, and so on, until the funds to be invested are exhausted.13 Thus, a government agency choosing among investment projects, say, high-yielding varieties of seeds, oil wells, textile factories, sugar refineries, flour mills, primary education, and training industrial managers, should be guided by the following rule: Maximize the contribution to national product arising from a given amount of investment.

What discount rate to use?. The present value of the net income stream is critically dependent on the discount (or interest) rate used. To illustrate, the present value of an investment of $1,000, with a net income stream of $130 per year over the next 20 years, can change from more than $1,000 to less than $1,000, if the discount rate is raised from 10 percent to 15 percent.

The influential manual written by the Oxford professors Ian M. D. Little and James Mirrlees for the OECD (an organization of developed capitalist countries) indicates that the discount rate should be set high enough to equate new capital formation (investment) with the supply of domestic savings and capital imports available (say K1 in Figure 11-3). At a given discount rate (r), V/K diminishes (the V/K curve is downward sloping) as capital projects increase. The V/K schedule rises (shifts to the right) as discount rates decrease and falls (shifts to the left) as discount rates increase.

Given the supply of savings and capital imports, planners should choose a discount rate so that the number of investment projects is consistent with a V/K equal to one; that is, present value of the net income stream is equal to the value of the capital invested (Equation 11-1). A too-low discount rate (r = 10 percent in Figure 11-2) results in excessive demand for investment, K1K2 and often a large international balance of payments deficit. For V/K to equal 1 (in Figure 11-3) at the point corresponding to the number of capital projects available, K1, the discount rate must be 12.5 percent. A too-high discount rate (r = 15 percent) results in too little investment, K0, so that the discount rate must be lowered to 12.5 percent to spur decision makers to use the savings and capital imports available.

Little and Mirrlees think most LDCs should use a real, or inflation-adjusted, interest rate of 10 percent. To illustrate, suppose $100 today and $200 next year are equivalent in buying power. A real interest rate of 10 percent would require a nominal

13After the projects are ranked, you may be able to increase the present value of all projects by shifting resources from projects with low V/K to those with high V/K Assume project A has a V/K of 1.8 and project B of 1.0. Switching a marginal dollar from project B to project A means that V/K for that dollar investment is increased from 1.0 to 1.8. Switches can continue until V/K is maximized; V/K is equalized for the last dollar invested in each project. However, in practice, when the project size is lumpy or discontinuous, as in the case of a dam or steel mill, these switches may not be possible.

382 Part Three. Factors of Growth

FIGURE 11-3. V/K, Discount Rates, and Capital Projects.

Planners should choose a discount rate (for example, r = 0.125) so that the marginal project included has a V/K = 1 and just uses up the total investment funds available.

interest rate of 120 percent per year so that $220 would be repaid next year for a loan of $100 today.

In practice, they suggest the trial use of three rates – high, medium, and low – to sort out projects that are obviously good and obviously bad. The marginal ones can be put off until the planners see how large the investment program will be and whether any better projects come along to displace the marginal ones (Little and Mirrlees 1968; Baldwin 1972:20; Alchian and Allen 1972:467–468).

Risk and uncertainty. It is difficult to rank investment projects whose net income streams are risky or uncertain. Risk is a situation in which the probabilities of future net returns occurring are known. To calculate V (Equation 11-1), decision makers can specify the whole set of alternative net income streams, computing the expected present value of the alternative outcomes, each weighted by its probability. This approach is especially appropriate for risk-indifferent government planners who have numerous projects, a long time in which to work, and considerable borrowing capacity in the event of unexpected shortfalls, especially as governments (or even giant corporations) can pool risk. Indeed, the larger the population, the lower the projects’ risk per individual citizen. To be sure, private individuals bear some risks, for example, students enrolled in courses in mechanics, farmers using high-yielding varieties of rice, and slum dwellers resettled in public housing. Moreover, individual risks from public investments vary depending on the distribution of income, preferences, and tax rates (Arrow and Lind 1970:364–378). Decision makers can, however, adjust expected present value for risk-taking or aversion. For example, the risk averse can place less value on probability distributions with a wide dispersion around the mean.

Many LDC investment choices are characterized by uncertainty, where the probabilities of net returns occurring are unknown. Yet this does not mean that planners must forgo project appraisal. Although the outcome of a particular investment may be uncertain, the risk of the entire investment program is negligible. Although the characteristics of success are uncertain, the ingredients for outright failure (political unacceptability, management incompetence, and so on) may not be. Meticulous feasibility studies of the project will help planners evaluate their abilities to respond to difficulties (often unforeseen). Although planners may not be able to rank some projects by V/K, they may still be able to make careful nonquantitative comparisons between projects (Yotopoulos and Nugent 1976:376–377; Knight 1921).

Differences between Social and Private Benefit–Cost Calculations

Under restrictive assumptions, the invisible hand of the market, dependent on thousands of individual decisions, will guide producers toward maximum social welfare. In an economy that consists of perfectly competitive firms that (1) produce only final goods, (2) render no external costs or benefits to other production units, (3) produce under conditions of constant (marginal opportunity) costs, and (4) pay marketclearing prices for production factors, a private firm that maximizes its rate of return also will maximize the increase in national product.

However, the social and private profitability of any investment are frequently different. When Equation 11-1 is used for the private firm rather than national-planning authorities, B becomes benefits and C costs incurred by the firm from the project, and r becomes the prevailing rate of interest that the firm pays on the capital market. Private investors want to maximize the commercial profitability of the investment. By contrast, the national planner is likely to consider not only the internal rate of return to a given investment project but also its effect on the profitability of other production units and on consumers. The following discussion examines the divergence between private and social marginal productivity.

EXTERNAL ECONOMIES

As indicated in Chapter 5, external economies are cost advantages rendered free by one firm to another producer or a consumer. So although the irrigation authority may not recover its investment in dams, reservoirs, canals, pumps, and tubewells directly, increased farm yields because of improved water supplies may make the social profitability of their investment quite high. Likewise, revenues generated by vaccinating people for measles, rubella, polio, and cholera may not cover costs but may substantially increase net social benefits by improving the health and productivity of the population. By contrast, the costs of external diseconomies, such as environmental pollution arising from iron smelting, chemical, and fertilizer plants, must be added to direct costs to arrive at any investment’s net social impact.

The Dakha, Bangladesh, municipal authorities should consider externalities when they decide whether to build an underground railway of a given design. Officials can estimate the initial capital outlays spread over 8 years (compounding to get the value

384Part Three. Factors of Growth

of K in year 0) and against which must be set the stream of future net social benefits (gross benefits less operating costs) spread over 40 years but discounted to year 0.

Net social benefits will exceed net financial benefits if only because a lower fare would produce greater social benefits while reducing net receipts. The largest net benefit occurs when the fare is equal to the marginal operating cost, which varies throughout the day. But it is less cumbersome to hold the fare constant at average operating cost (or above average at peak hours, with a concessionary rate for other times).

Part of the annual gross benefit of the railway is the total receipts expected in each of the 40 years (say, 50 cents per ride times the number of riders). External benefits include the difference between 50 cents and the most people are prepared to pay for alternative road transport (auto, taxi, bus, bicycle, and rickshaw – a human-powered carriage) and the time, comfort, and safety benefits to riders (or to road users from less congestion).

If the capitalized value were $200 million in year 0 and the discount rate is correct, Dakha should build the underground if the sum of discounted future net benefits exceeds $200 million.

How do we calculate benefit cost if the railway adds equipment and other capital costs during the life of the underground? E. J. Mishan (1982) favors putting capital costs and operating costs together and entering all payments and external diseconomies as costs and all gross receipts and external economies as benefits. Thus, we invest if annual net benefits (B − C), which replace V in Equation 11-1, are at least zero (Gramlich 1990).

Planners be forewarned. Politicians have discovered the concept of external economies, using vague references to them to support inviable steel plants, dams, or port projects in their local districts. But even though planning agencies are generally responsible to the political leadership, careful feasibility studies, including evidence of the existence and the extent of externalities, can make a planning agency’s recommendations difficult to override.

DISTRIBUTIONAL WEIGHTS

The social value of an investment may depend on who receives its benefits and bears its costs. In Equation 11-1, consumer goods produced for the rich count as much as for the poor. A government may express its goals of improving income distribution by weighing an investment’s net benefits to the poor more heavily than to the rich (U.N. Industrial Development Organization 1972:75–80, 135–148).

In the 1950s, 1960s, or 1970s, the governments of Sudan, Kenya, and Tanzania, seized land from peasants, with traditional community use rights, to transfer to “modernizing” agricultural elites, often allied with leading politicians. The transfer resulted in more exploitative land practices and the encroachment on the livelihoods or even the eviction of peasants. Elites often manipulate benefit–cost calculations to justify these transfers. Decisions about interpersonal asset transfer are not amenable to simple benefit–cost calculations. The University of Massachusetts economist James Boyce

(2002:24) poses three questions concerning transfers from one party to another: “Who reaps the benefits? Who bears the costs? Why are the winners able to impose costs on the losers?” Many economists fail to raise such questions of power and distribution, instead analyzing the issue as one of social net benefit disconnected from interpersonal gains and losses.

INDIVISIBILITIES

The returns to many indivisible investment projects, such as bridges, dams, rail lines, and electrical plants, depend on economies of scale in the use of technology, capital, or labor (see Chapter 5). Electricity can be generated, for example, in small-scale coal or oil-based steam plants or in large-scale hydroelectric or nuclear power plants.

The benefit–cost calculation still applies in the presence of indivisibilities. However, they make the role of engineers and others who formulate the project more important. Thus, before evaluating a project on the basis of a given technology and scale, the project evaluator should be certain to ask engineers and others if all feasible technologies and scales have been considered (Yotopoulos and Nugent 1976:374).

MONOPOLY

A monopoly is a single seller of a product without close substitutes; an oligopoly has few sellers, with interdependent pricing decisions among the larger firms in the industry. Unlike pure competition, in which the individual firm faces a horizontal (perfectly elastic) demand curve, the pure monopolist faces a downward-sloping demand curve. Prices are higher and outputs lower in monopolistic resource and product markets than they are under pure competition.

Monopolistic restraints are frequent in LDCs, especially in the early stages of manufacturing. In many instances, industrial concentration is a by-product of official government policy, especially of fiscal incentives and controls. Also large firms know how to deal with the bureaucracy. Rare is the LDC government with the political ability and willpower to pursue antimonopoly policies. But if such a course is followed, trusts can be broken up; subsidies or preferential licensing of monopolistic pioneer companies eliminated; foreign ownership shares reduced; foreign companies made to divest themselves of ancillary production or marketing channels; or nationalization of monopolies undertaken.

However, nationalized enterprises may still behave as a private monopolist in pricing and output policies. In other instances, a monopoly may be natural, as when internal economies of scale bring about a continuously falling average cost curve that makes having more than one firm in an industry inefficient. Examples of these natural public monopolies may be telephone, electricity, water, or postal service. In these cases, fixed production and distribution costs are so large that large-scale operations are necessary for low unit costs and prices. Where competition is inappropriate, LDC governments can place monopolies under public ownership or regulation, so that consumers benefit from scale economies. Government can further