Alternative Investment Criteria for Resource Allocation | Economics

In this article we will critically examine marginal reinvestment quotient criterion put forward by galenson and leibenstein and growing points criterion.

Marginal Reinvestment Quotient Criterion:

Marginal reinvestment quotient criterion has been suggested by Galenson and Leibenstein which seeks to maximise investible surplus per worker so that it can be reinvested to maximise rate of growth of the economy. It aims at maximising per capita income and consumption at some future point of time rather than maximise the income or consumption at the present. For this purpose the rate of savings or surplus should be maximised so that the rate of reinvestment can be maximised. Hence, each unit of investment should be chosen that will give each worker greater productive power than any other alternative.

This criterion assumes that profits are largely saved and reinvested and that wages are largely spent on consumption. Actually, according to the advocates of this criterion, the amount available for reinvestment is determined by ‘net productivity per worker minus consumption per worker’, called the marginal reinvestment quotient. The formula given for the rate of reinvestment is as –

r = (p-ew) / C

Where, r = rate of investment

p = net output per machine;

e = the number of workers per machine;

w = real wage rate;

c = cost per machine, (i e., c is the cost of investment made in machine)

To maximise the flow of investment that is created by a unit of investment today, it is recommended that the capital resources should be so allocated among the alternative uses that the marginal per capita reinvestment quotient is the same in different alternatives. The application of the law of equi-marginal return will bring about an optimal utilisation of scarce capital resources.

According to this criterion, capital-intensive projects should be undertaken in developing countries even though capital is scarce because in this way output per capita will be maximised. Maximisation of reinvestible surplus in the present is required so that each additional unit of labour is equipped with maximum possible capital so that output per worker is maximised to achieve the highest possible growth rate.

This criterion implies the allocation of investment resources to the projects with a much higher capital-intensity than if the aim was to maximise consumption in the present. The greater capital intensity, given the wage rate, ensures higher profits which when reinvested will bring about higher growth rate. With higher growth rate at some future point, higher consumption per capita will be achieved. The focus of Galenson and Leibenstein is the choice of projects or industries that causes higher rate of capital accumulation on which rate of economic growth depends.

Elaborating Galenson-Leibenstein criterion, Thirlwall writes, “It is designed to take account of the influence of projects on the rate of capital formation, or to put it another way, to take account of the choice of projects on the distribution of income between savers and spenders. The economic basis of the approach is the belief that the level of per capita output is largely determined by the capital-labour ratio and the amount of capital per worker must largely depend on the level of profits (the surplus over wages) stemming from the original investment.”

It may by noted that Galenson and Leibenstein argued against the labour-abundant countries specialising in labour-intensive industries in line with their comparative cost on the ground that labour-intensive industries would yield lower ‘reinvestment quotient’. Their criterion favours-capital intensive industries because it will not be necessary to pay more wages and as a result will generate more surplus or profits over wages and thereby will ensure higher rate of investment.

According to them, if labour-intensive industries are given higher priority, more wage employment will be created, more additional wages will be paid which will be consumed, there will be less surplus or saving and investment. Therefore, Galenson and Leibenstein recommend strategy of development which favour capital-intensive basic heavy industries such as iron and steel, fertilizers, machine toots, power generating and other capital-producing industries as they have a higher ‘reinvestment quotient’ or those which maximise productivity per worker minus consumption.

It is worthwhile to give an example which Galenson and Leibenstein give in their article. They explain that, given certain assumptions, an amount of employment generated over a period of time by an initial investment of Rs 1,200 in various kinds of cotton textile machinery. They say that if this sum of funds is invested in handlooms i.e., cottage industries, it would initially generate employment for 35 persons and since there will be no margin for reinvestment (almost all output being paid as wages), there will be no growth even after 25 years and the amount of employment provided will still be thirty-five. On the other hand, if the same amount of funds (i.e., Rs 1,200) is invested in a large-scale modern mill, it will initially create employment for 5 workers but because it will yield large surplus for further reinvestment and growth, the extra employment generated will exceed 35 after 15 years.

It is noteworthy that similar logic was used by the supporters of basic heavy industry strategy of development proposed by P C. Mahalanobis. Thus, to quote Dr. K. N. Raj, “The logic here is the same as the more common proposition that a higher rate of investment, i.e., a larger proportion of productive factors used for capital formation would result in a smaller volume of output being available for consumption in the short run but that over a long period, it would result in higher level of growth of consumption; the difference is that the choice is here stated as between investment in capital goods and consumer goods industries.”

It follows from above that Galenson-Leibenstein criterion does not give much priority to present consumption and welfare and focuses on accumulating capital for greater output and consumption in future. The application of this criterion leads to the choice of highly capital-intensive projects and larger sacrifice of present consumption. Galenson and Leibenstein implicitly assume that the gain in future output and consumption will more than offset the consumption losses in the initial periods. The capital-intensive projects are advocated also on the ground that they will provide training to the workforce and experience to management and these are the things that the developing countries lack the most.

Critical Evaluation:

However, this Galenson-Leibenstein criterion suffers from some serious objections:

First, it is not necessarily always true that the most capital-intensive techniques ensure highest rate of reinvestment. Increased capital intensity while raising labour productivity, also raises the cost of capital. So the rate of reinvestment will increase only if the rise in labour productivity is more than the increase in capital cost.

Second, this criterion is based on the assumption that all wages are consumed and all profits are reinvested. But, it is quite likely that as with higher capital intensity, the productivity of workers will be greater which will prompt them to get their wages increased. This will make the workers better off than before and will thus able to contribute to savings. Similarly, it is unlikely that the whole profits would save and reinvested.

Third, it has been assumed that the proportion of consumption national income remains unchanged over time. But it is unlikely to be so. The consumption of the community will normally increase with the increase in employment. So the volume of investible surplus will decline unless, of course, with additional employment, the increase in output is more than the increase in consumption.

Fourth, increase in capital intensity of production is likely to render some labour unemployed. And the unemployed labour has got to be provided with something to survive. There is thus the social cost of unemployment which the authors have neglected.

Fifth, the criterion values future income and consumption more than the present income and consumption. That would mean overstraining the present generation for the comforts of the future generation. What is required is a proper balance between the present and future income and consumption.

Sixth, the criterion is suggestive of a greater emphasis on the capital goods sector to the neglect of the consumer goods sector. But this is fraught with serious socio-economic consequences. There may be social unrest due to inflation resulting from the scarcity of essential consumer goods. This happened during the Second and Third Five Year plan periods.

Lastly, the application of this criterion is likely to produce some undesirable social effects- It will accentuate inequalities in income and wealth in the community, because the capitalists will gain at the expense of the wage earners.

Growing Points Criterion:

It has generally come to be accepted that the basic consideration in selecting industries for development in an underdeveloped economy, is the prospect of external economies. Allyn Young drew attention to this important consideration in 1928, and Rosenstein-Rodan in 1943 made out a strong case for developing those industries which would create conditions favourable to the growth of other industries.

Some enterprises may promote economic development more by indirect contribution to the output of the economy than by their own direct contribution. Investment in infrastructure projects has a high potential for development. For example, the development of transport, roads and highways or of sources of fuel and power influence both the costs and the market possibilities of diverse manufacturing industries or investment in iron and steel and engineering industries increase the growth potentiality of industry in general.

From the standpoint of supply, it thus emerges that one of the requirements of investments should be that it creates additional external economies. From this point of view, it will be better to direct investment so as to bring about and promote horizontal and vertical integration of the process of production and introduce a more effective and fruitful division of labour. Investment should be in such directions as to help the industries avail themselves jointly of facilities like pool of technical skill, a common source of raw materials or better utilisation of social overheads. In this manner, the economy will move nearer to an optimum increase in national output.

On the demand side, when considering particular industries, one cannot assume that supply will create its own demand. There must be markets for the commodities produced. Where are the potential markets in the poor countries? Investment should be made in those industries which would have a readily available demand. The demand for building and construction is likely to be high, since poor countries are deficient in roads, railways, houses and public utilities. Investment in export industries for which there is a foreign demand is another attractive area, and import substituting industries provide still another potential choice of investment.

Giving Higher Priority to Industries with Greatest ‘Total Linkages’:

It is important to refer here the unbalanced growth strategy of Hirschman who favoured unbalanced growth and pointed out that economic growth cannot be accelerated by an even distribution of investment among various sectors or industries. He, on the other hand, strongly feels that investment priority should be given to strategically selected industries—industries which have the greatest’ total linkage’.

The establishment of any industry may encourage investment in both the succeeding and preceding stages of production. That is to say, the setting up of a particular industry may produce both the ‘forward’ and ‘backward’ linkages. In this view, therefore, investment should first be made in those industries or sectors which have the greatest ‘total linkage’.

The same industries need not necessarily be the industries with greatest ‘total linkage’ effect in all countries. For any country, the industries with the highest potential of total linkage can be determined from the input-output tables of the economy.

The building of such projects or industries as have the highest linkage effects would produce a spurt of investment over a variety of other fields. The crux of this approach, therefore, lies in directing investment in judiciously selecting industries that have the highest ‘total linkage’ score.

These considerations of external economies, total linkages, and of available market demand, may be summarised by saying that investment should be directed to ‘growing points’ in the economy. In the initial stages of economic development, it is highly useful to concentrate on certain focal points which seem to have the promise of more rapid growth. These focal points refer to those projects the products of which have a readily available demand and which provide significant external economies to other existing firms and industries and greater linkages or they will generate demand for supplementary products and services. From these focal areas a chain reaction usually starts that gradually spreads chain to the remaining areas of the economy. Thus even an unbalanced process of initial economic growth has every possibility of ultimately merging into the broader requirement of balanced growth.

Employment Absorption Criterion:

It is well known that in the developing but overpopulated countries, labour supply is abundant and cheap. There is large-scale unemployment or underemployment, especially in the agricultural sector in the form of disguised unemployment. Hence, it is suggested such investments should be undertaken which are capital-saving and labour-absorbing. In other words, such industries should be given higher priority which are labour-intensive.

Besides providing more employment, such labour- intensive industries and techniques will raise the level of consumption because the newly employed labour will spend most of their incomes on consumption. Higher propensity to consume will stimulate further investment which will accelerate economic growth. Also, such techniques will be conducive to a high degree of economic equality by raising the level of incomes of the working class people.

But the defect of such labour-techniques is that they do not necessarily maximise the national output. Labour-intensive techniques are not as productive as the capital-intensive techniques. Low labour productivity may be perpetuated. Besides, the quality of the end-products suffers. However, for a country suffering from widespread unemployment, a very suitable criterion of investment is that investment should be made in those industries which have a high employment potential. Investment will also depend on the type of unemployment it is sought to cure. If unemployment among the educated classes is more rampant, then it will be necessary to create employment opportunities specially for this class of people by opening more schools, expanding facilities for teachers’ training and developing small industries which the educated people may be able to manage.

If, on the other hand, it is a case of disguised unemployment among the rural masses, then it will be necessary not only to employ them in the urban areas by opening there suitable avenues of employment but also absorbing them in agriculture by increasing capital formation especially expansion of irrigation, in it and undertaking land reforms to raise productivity and cropping intensity in agriculture. Setting up suitable agro-processing industries in close proximity to the rural areas can be very helpful. Rural development programmes may be intensified to absorb surplus labour in productive employment.

Conclusion:

From the above analysis of the various investment criteria, it is clear that we cannot lay down dogmatically the criterion or criteria which should guide us in undertaking investment. There are so many considerations influencing investment that one would easily lose one’s way in the maze of numerous investment criteria. In this possible confusion it is best to bear in mind the economic situation at the time and the principal objective or objectives that are desired to be achieved.

The investment must accord with their objectives. Of the criteria explained above one or the other will determine investment as the situation demands or according to the objective kept in view. The latest investment criterion which has gained much popularity in recent years is of ‘Social Cost-Benefit Criterion’.