Nafziger Economic Development (4th ed)

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reduce resource misallocation from public monopolies if they are required to use competitive pricing policies – where marginal cost is equal to price.

Planners must realize that monopolistic behavior at a later stage in the production process can affect benefits at an earlier stage. Suppose an irrigation project leads to growing more sugar beets, so more sugar is refined. If the sugar refiner has a monopoly, the sugar beet farmers’ demand for irrigation water will not be a sufficient indication of such a project’s merits. If refiners were producing sugar competitively, they would use more beets, in turn increasing the demand for water. Obviously, the more monopolistic an industry, the more scope there will be for improving allocation through antimonopoly policies and marginal cost pricing. Even though economists can recommend such improvements, their only recourse in calculating benefit cost is to accept present and future prices and correct them for measurable externalities (Prest and Turvey 1965:683–735; Mishan 1982:111–153; Case and Fair 1996: 322–346).

SAVING AND REINVESTMENT

The usual benefit–cost analysis does not consider the effect of an investment’s income streams on subsequent saving and output. Let us compare the irrigation project discussed earlier to a rural luxury housing project. Assume both projects have the same annual net income streams over a 20-year investment life. Let us focus only on the $200 annual net return ($99.43 discounted to the present) in the fifth year. Suppose that the commercial farmers whose incomes increased by $200 from the irrigation project invest $100 in farm machinery and buildings, which in turn increases net farm earnings for the next 20 years. Assume, though, that all of the income from the luxury housing project is spent on consumer goods. Should the additional income (discounted back to the present) attributed to the commercial farmers’ investment not also be included in the net income streams of the initial irrigation project? By contrast, that none of the net earnings from luxury housing is reinvested would make that project less desirable.

Although it is not usually done, benefit–cost analysis can consider the effect of a project’s net returns on subsequent saving and output (Galenson and Leibenstein 1955:343–370; Eckstein 1957:56–85). In some instances, the savings effect will conflict with the distributional effect, as higher income recipients usually save and reinvest more. Furthermore, as the income streams are even further in the future, their discounted value may be small, especially with high interest rates. Although accurate prediction is not possible, we can consider how much people are likely to save from income resulting from a particular investment project.

FACTOR PRICE DISTORTIONS

Chapter 9 indicated that wages in LDCs are frequently higher, and interest rates and foreign exchange costs lower, than market-clearing rates. Because of these distortions, the private investor may use more capital goods and foreign inputs and less labor than is socially profitable.

Shadow Prices

Prices do not measure social benefits and costs of an investment project if external economies and diseconomies, indivisibilities, monopolies, and price distortions are present. Prices observed in the market adjusted to take account of these differences between social cost–benefit and private cost–benefit calculations are shadow prices.

Planners use shadow (or accounting) prices to rectify distortions in the price of labor, capital, and foreign exchange. The following examples illustrate how this adjustment is usually made. The shadow wage for unskilled industrial labor, based on its alternative price in agriculture, may be only Rs. 0.50 per hour when the prevailing wage is Rs. 1.00 per hour. Even though businesspeople borrow money at subsidized rates from government loan boards at only a 12-percent interest rate, the shadow interest rate, based on the cost of capital on the world market, may be 18 percent. The shadow (equilibrium) foreign exchange rate may be Rs. 26 = $1, whereas the actual rate, repressed by import and exchange restrictions, may be Rs. 13 = $1. Thus, the foreign-made computer purchased by a domestic firm for only Rs. 26,000 ($2,000) has a shadow price of Rs. 52,000. Correspondingly, the accounting price of raw jute exported for $1,000 a ton is Rs. 26,000 compared to the Rs. 13,000 received by the seller at the official exchange rate.

Little and Mirrlees (1968:92) determine the shadow prices of both inputs and outputs by their world prices, because these “represent the actual terms on which the country can trade.” However, they argue that, as traded goods are valued in world prices, nontraded goods must be similarly valued, in order to “ensure that we are valuing everything in terms of a common yardstick.”

Very few economists favoring the use of shadow prices question Little’s and Mirrlees’s valuations of goods that are or could be traded. But to value nontraded items in world prices involves a lot of trouble for doubtful advantage. Usually, input– output data and purchasing power equivalents do not exist, so we cannot accurately value local goods in terms of world prices. In most countries, it is probably simpler and sufficiently accurate to (1) use world prices for inputs and outputs that are traded; (2) convert these values into domestic currency at an exchange rate (using a market rate if the official rate is badly out of line); and (3) value at domestic factor costs (shadow or market prices as appropriate) for nontraded inputs. In most investment projects, any distortions in the values of nontraded inputs are not likely to be important (Baldwin 1972:16–21).

Shadow pricing can open up Pandora’s box. To illustrate, the shadow price of capital may depend on a distorted wage whose shadow rate requires calculation, and so on for other factors. Scarce planning personnel may have more important tasks than computing shadow prices from a complex system of interindustry equations, especially when data are lacking and shadow rates continually change. In addition, a government that, say, hires labor on the basis of a shadow wage lower than the wage paid increases its payroll costs and budget deficit (Stolper 1966:82–90).

Many developed capitalist countries have prices near enough to equilibrium that shadow prices are not needed for government planning. It would seem much easier

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for LDC governments to change foreign exchange rates, interest rates, wages, and other prices to equilibrium prices, which would make planning less cumbersome and time consuming and improve the efficiency of resource allocation.

Chapter 9 discussed how to decrease factor price distortions by (1) cutting wages and fringe benefits, (2) reducing interest rate subsidies, and (3) increasing the price of foreign exchange to an equilibrium rate. Yet price distortions are difficult to remove. Low elasticities of demand for urban labor may limit how much wage reductions expand employment (see Chapter 9). Increased foreign exchange prices (say, from Rs. 13 = $1 to Rs. 26 = $1) will not improve the balance of trade (exports minus imports of goods) if sums of the export and import demand elasticities are too low. An inelastic demand for an LDC’s exports results in only a modest increase in rupee export receipts, which may not compensate for the increase in rupee import payments from inelastic import demand (that is, a relatively small quantity decline in response to the relatively large rupee price increase from the increased foreign exchange price). In LDCs, import demand elasticity is often low as a result of high tariffs, extensive quantitative and other trade restrictions, and exchange controls.

Moreover, equilibrium prices may conflict with other policy goals. The LDC governments may not want to weaken labor unions’ ability to protect the rights and shares of workers against powerful employers. Subsidized capital may be part of a government plan to promote local enterprise. Young, growing debtor nations borrowing capital to increase future productivity (for example, the United States and Canada in the late 19th century) may not be able to attain a foreign exchange rate that eliminates an overall balance of payments deficit.

Furthermore, existing distortions may be supported by economic interests too powerful for government to overcome. These interests may include organized labor, local enterprises receiving subsidies, industries competing with imports, firms favored with licensed foreign inputs, industrial and import licensing agencies, and central banks.

The LDC governments may be faced with a choice between the Scylla of cumbersome shadow price calculations and the Charybdis of factor price modification. Although the case for adjusting LDC prices nearer to their equilibrium rate is strong, the technical and political obstacles to doing so are often formidable.

Conclusion

1.The growth in total factor productivity is the increased worker productivity arising from factors other than increases in capital per worker.

2.Capital formation and technical progress are major factors responsible for the rapid economic growth of the West and Japan in the last 125–150 years.

3.Economic growth cannot be explained merely by increases in inputs.

4.Econometric studies of developed countries indicate that the increase in the productivity of each worker per unit of capital is a more important source of growth than the addition in capital per worker. Major explanations for this increase in

productivity are advances in knowledge, greater education and training, learning by experience, organizational improvement, economies of scale, and resource shifts.

5.However, research on the sources of growth in developing countries provides evidence that the contribution of capital per worker is more important to economic growth than that of worker productivity per unit of capital. Reasons for the greater contribution of capital to growth in LDCs are higher marginal productivity of capital and higher growth rates of capital.

6.Technical progress results from a combination of research, development, invention, and innovation.

7.Technical knowledge acquired from abroad is costly and usually incomplete.

8.LDC planners must examine existing technologies for possible substitution of labor for capital. Nevertheless, the maximization of labor absorption is inadequate as an investment criterion. Labor-intensive techniques may sometimes not be used because of fixed capital–labor ratios in the industry, the high cost of adapting and modifying existing technologies, scarce administrative and managerial resources needed to implement labor-intensive techniques, and distortions that increase the price of labor relative to that of capital.

9.Social benefit–cost analysis chooses investment projects that maximize the discounted net social benefits per unit of capital invested.

10.The discount rate should be set high enough to equate investment with savings and capital imports.

11.The investment planner who wants to avert risk can place less value on probability distributions with a wide relative dispersion around the average.

12.Market prices must be adjusted for externalities, distribution, indivisibilities, monopolies, and factor price distortions to obtain shadow prices. These prices aid the planner in adjusting returns away from commercial profitability to social profitability.

13.Computing shadow prices is usually a cumbersome and time-consuming task. Setting factor and foreign exchange prices closer to equilibrium rates may be more effective in improving resource allocation.

14.After a lag, computers and ICT have increased productivity greatly.

22.How much effect have computers, electronics, and information technology had in increasing productivity, especially in LDCs? Give examples. How great is the digital divide between DCs and LDCs?

GUIDE TO READINGS

Stiglitz (1998:197–210) examines the market for information and the extent of market failure. The economic historian Paul David (1991:315–348) discusses the long time for major new technologies to influence an economy’s aggregate productivity. Pohjola (2001) includes several case studies on the effect of information technology on economic development. D’Costa (2003a:51–82; 2003b:1–26; 2003c:297– 305) is a leading expert on the Indian software industry. The World Bank’s annual World Development Indicators (also on CD-ROM) has the latest data on ICT, similar to World Bank (2003h:297–305). UNCTAD (2002) has a report on e-commerce, e-finance, and economic development. Edwards (2002:19–43) argues that the Internet and ICT are not the answer to accelerating growth in Latin America and other LDCs. Arora and Gambardella (2005) and Wilson (2005) discuss IT in LDCs.

For Handbook of Development Economics information, see Behrman and Srinivasan (1995d) on resources, technology, and institutions; Besley (1995) on savings and credit; Evenson and Westphal (1995) on technological change and technology strategy; and Stiglitz (1988) on economic organization, information, and development.

The annual World Development Report of the World Bank has information on LDC saving and investment rates. Yotopoulos and Nugent (1976:393–395) and Panchamukhi (1986) critically review ICORs and growth.

Arrow (1962:154–194) is the classic article on learning by doing. Boardman, Greenberg, Vining, and Weimer (2001) have a textbook on benefit–cost analysis. Other manuals providing guidelines for investment choice and benefit–cost analysis are Gramlich (1990), Mishan (1982), and Little and Mirrlees (1968). Baldwin’s essay (1972) provides a brief, simple explanation of benefit–cost analysis.

Adelman (1961) discusses the classical approach to saving decisions. Lewis (1954:139–161), Ranis and Fei (1961:533–565); and Fei and Ranis (1964) analyze the increase in saving in a dual economy. Bruton (1965:154–158) is a good source for ideas on how to raise rates of capital formation in LDCs.

Griliches (1994:1–23) examines research and development, technical progress, and growth in productivity. Fransman (1986); and Dosi, Freeman, Nelson, Silverberg, and Soete (1988) analyze technical progress, whereas Kennedy and Thirlwall (1972) have a survey of technological change.

Schumacher (1973) makes a strong case for using intermediate technology, especially in LDCs.

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and that innovation brings about economic growth. He feels that the entrepreneur carries out new economic combinations by (1) introducing new products, (2) introducing new production functions that decrease inputs needed to produce a given

output, (3) opening new markets, (4) exploiting new sources of materials, and

(5) reorganizing an industry.

The Schumpeterian model begins with a stationary state, an unchanging economic process that merely reproduces itself at constant rates without innovators or entrepreneurs. This model assumes perfect competition, full employment, and no savings nor technical change; and it clarifies the tremendous impact of entrepreneurs on the economic process. In the stationary state, no entrepreneurial function is required, as the ordinary, routine work, the repetition of orders and operations, can be done by workers themselves. However, into this stationary process, a profit-motivated entrepreneur begins to innovate, say, by introducing a new production function that raises the marginal productivity of various production resources. Eventually, such innovation means the construction of new plants and the creation of new firms, which imply new leadership.

The stationary economy may have high earnings for management, monopoly gains, windfalls, or speculative gains, but has no entrepreneurial profits. Profits are the premium for innovation, and they arise from no other source. Innovation, however, sets up only a temporary monopoly gain, which is soon wiped out by imitation. For profits to continue, it is necessary to keep a step ahead of one’s rivals – the innovations must continue. Profits result from the activity of the entrepreneur, even though he or she may not always receive them.

New bank credit finances the innovation, which, once successfully set up, is more easily imitated by competitors. Innovations are not isolated events evenly distributed in time, place, and sector; they arise in clusters, as a result of lowered risk. Eventually, the waves of entrepreneurial activity not only force out old firms but also exhaust the limited possibilities of gain from the innovation. As borrowing diminishes and loans are repaid, the entrepreneurial activity slackens and finally ceases. Innovation, saving, credit creation, and imitation explain economic growth, whereas their ebb and flow determine the business cycle.

THE SCHUMPETERIAN ENTREPRENEUR IN DEVELOPING COUNTRIES

For William J. Baumol (2002), the pressures for innovation under oligopolistic competition, with a few giant firms dominating the market, has provided incentives for unprecedented growth in the last century or so. Indeed, among large, high-tech business firms, innovation has replaced price as the important competitive weapon in the market. Capitalism is more likely to encourage productive entrepreneurship rather than rent-seeking (that is, nonproductive) pursuit of profit.

However, Schumpeter indicates that his theory is valid only in capitalist economies prior to the rise of giant corporations. Indeed, Schumpeter fears oligopolistic concentration may give rise to the fall of capitalism. Thus, Schumpeter’s theory, assuming perfect competition, may have limited application in mixed and capitalist

LDCs, as many industries in these countries, especially in manufacturing, are dominated by a few large firms.

Moreover, it seems unrealistic to preclude the possibility that Schumpeterian innovation may mean expansion of already existing firms. In fact, in the real world, characterized by imperfect competition, an established organization would frequently have an advantage in developing new techniques, markets, products, and organizations.

Furthermore, Schumpeter’s concept of the entrepreneur is somewhat limited in developing countries. The majority of LDC Schumpeterian entrepreneurs are traders whose innovations are opening new markets. In light of technical transfers from advanced economies, the development of entirely new combinations should not unduly limit what is and is not considered entrepreneurial activity.

People with technical, executive, and organizational skills may be too scarce in less-developed countries to use in developing new combinations in the Schumpeterian sense. And, in any case, fewer high-level people are needed to adapt combinations from economically advanced countries.

STAGES IN INNOVATION

Technical advance involves (1) the development of pure science, (2) invention,

(3) innovation, (4) financing the innovation, and (5) the innovation’s acceptance. Science and technical innovation interact; basic scientific advances not only create opportunities for innovation, but also economic incentives and technical progress can affect the agenda for, and identify the payoffs from, scientific research. Links from production to technology and science are often absent in LDCs. Yet low-income countries can frequently skip stages 1 and 2 and sometimes even stage 3, so that scarce, high-level personnel can be devoted to adapting those discoveries already made (Maclaurin 1953:97–111; Fransman 1986:47–48).

Entrepreneur as Gap-Filler

The innovator differs from the manager of a firm, who runs the business along established lines. Entrepreneurs are the engineers of change, not its products. They are difficult to identify in practice, as no one acts exclusively as an entrepreneur. Although they frequently will be found among heads or founders of firms, or among the major owners or stockholders, they need not necessarily hold executive office in the firm, furnish capital, or bear risks.

Entrepreneurship indicates activities essential to creating or carrying on an enterprise in which not all markets are well established or clearly defined, or in which the production function is not fully specified or completely known. The Nobel economist Ronald H. Coase identifies two major coordinating instruments within the economy: the entrepreneur, who organizes within the firm through command and hierarchy, and the price mechanism, which coordinates decisions between firms. The choice between organization within the firm or by the market (that is, the “make or buy” decision)