Resource Allocation in Developing Countries | Economics

How to allocate investment resources among competing industries or projects is a central issue facing all economies? However, the allocation of resources in developing countries assumes a great significance as capital is very scarce while the needs and aspirations of the people are very large. There is need for investment in agriculture to produce more food grains to feed the rapidly increasing population and more cash crops to fulfill the needs of raw materials for industrial growth. We require to invest in capital goods producing industries, in basic goods industries such as iron and steel, fertilizers, in numerous consumes goods industries and above all in infrastructure such as power, roads, highways, ports and airports.

Besides, more investment is required to be made in education and health which are now regarded as important drivers of growth. Given that resources are scarce, how much resources are allocated to each of these uses is a very difficult problem. No developing country can afford to take a leap in the dark and utilise its resources in a haphazard manner.

As a general rule it can be stated that we must make an optimum use of our economic resources. But the problem is how precisely to do it. It is necessary therefore to lay down certain criteria which should guide the allocation of scarce resources for planned economic development. What priorities should be given to various industries and projects so that not only rapid economic growth is achieved but also other objectives of planning are fulfilled. It is the pattern of investment allocation among different uses that will determine whether the paces of economic growth as well as its direction are such as we desire.

It may also be pointed out that the investment criteria will vary according to the objectives of development envisaged in the plan. There are several objectives that can be kept in view by the planners of a developing economy. The proper choice of criteria for investment allocation depends on the preference of the planners for achieving particular objectives. Thus, the planners may seek to raise the present level of standard of living (i.e. level of consumption) or maximise the rate of growth of the economy to achieve a higher level of consumption in future. The other objective may be to give higher priority to reduce the levels of poverty and unemployment which implies the choice of techniques and industries which have higher labour intensity.

It may be further noted that alternative criteria will affect economic growth differently. One type of investment may maximize total output over one period and another over a different time period. It is not therefore possible to have a criterion of investment capable of application in all periods. This is due to the fact that no economy is static. In a dynamic economy, situations changes calling for a change in investment strategy.

Marginal Rule of Resource Allocation:

Microeconomic theory tells us that in a perfective competitive market economy resources are efficiently or optimally allocated and used. Under conditions of perfect competition in both the product and factor markets marginal products of factors are equated in all their uses and as a result total output is maximum. This is known as the marginal rule of resource allocation and its fulfillment implies the achievement of efficiency or what is also called Pareto optimality, which ensures maximum social welfare with the given resources of the economy.

Now the question arises if the marginal rule of resource allocation leads to the achievement of efficiency, investment resources in a planned economy should be allocated to different industries, projects or uses in a way that marginal product of capital in different uses is equated to maximise total output, then why there is need for some other criteria to guide allocation of resources in a planned developing economy. The important reason for this is that marginal rule of resource allocation is static and is concerned with the maximisation of the present level of output or welfare with the given resources, while for developing countries we need the criteria which should ensure rapid growth of output and employment so as to maximise output and consumption over a long period.

The second reason for developing countries to adopt investment criteria other than the marginal rule is that the concept of efficiency or Pareto optimality ignores a number of factors that affect welfare of the society. Owing to a large number of imperfections in market and the existence of structural disequilibrium in the developing economies, the market prices of factors and goods on which the concept of Pareto efficiency is based do not truly reflect the social costs and benefits of production. Therefore, in developing countries the marginal rule of resource allocation for achievement of efficiency in resource allocation cannot be applied unless market prices are corrected so that they reflect social costs and benefits.

Let us explain in some detail why market prices do not reflect true social costs and benefits. The first important reason for this is that some projects, especially relating to infrastructure, generate external economies which are not taken into account by private enterprises in determination of their costs and prices. As a result, when external economies exist, social benefits will exceed the private benefits.

Unless some corrections are made for these external economies, social optimum or efficiency in resource allocation will not be achieved by applying the marginal rule. The second reason for the divergence of market prices from the social values of goods and factors is the existence of imperfections in the market such as monopolies, oligopolies and monopolistic competitions in both goods and factor markets and therefore the market prices determined under these conditions depart from the valuation of goods and services from the viewpoint of maximising social welfare.

Emphasizing the imperfections causing failure of market prices goods and factors to reflect their social values, Thirlwall writes – “If perfect competition does not prevail in the factor markets, the prices of these factors will not reflect their opportunity costs to the society so that employing factors up to the point where their marginal product equals their price will not produce a social optimum. Idle resources such as labour will be overvalued and scarce resources such as capital and foreign exchange will be undervalued and market prices must therefore be corrected to reflect the value of these resources to the society.”

Thirdly, the real world is dynamic and the present prices of goods and factors may not prevail in the future and therefore the optimum choice of investment among industries or uses on the basis of present prices of goods and factors may not ensure social optimum in the future.

Last but more important reason for non-applicability of the marginal rule to optimum resource allocation in developing countries is its assumption that the prevailing income distribution is optimal and is not adversely affected whatever pattern of resource allocation is chosen. If the pattern of investment chosen leads to the increase in income distribution, the output may be maximised but social welfare will be diminished. The concept of efficiency or social welfare maximisation is based on the assumption that prevailing income distribution is optimal.

If the choice of a particular pattern of resource allocation affects the income distribution adversely and renders a large part of labour force unemployed and poor represents a change for the worse. Guided by these concerns the Eleventh and Twelfth Five Years Plans of India, the objective is not just higher rate of economic growth but inclusive growth which means that benefits of growth should be widely shared in the society and poverty and unemployment be reduced. The achievement of efficiency as implied by Pareto optimality would not ensure this.

For the above reasons, there has been a long debate among economists about the appropriate criteria of investment allocation among different industries or projects for developing countries. The various criteria that have been suggested in this regard differ mainly in respect of what developing countries should seek to maximise, especially whether the present level of output or consumption should be maximised or rate of growth be maximised so as to achieve higher level of future consumption. Besides, as explained above, the difference about the appropriate investment criteria in developing countries also relates to the objectives of planned development in developing countries.

It may be further noted that various criteria were concerned with the allocation of capital as capital was considered as an important scarce resource in developing countries. However, some earlier writers on the subject considered foreign exchange resources as crucial scarce resource and proposed criterion that ensures balance of payments problem may not arise.

Furthermore, the investment criteria refer to the pattern of investment and to choice of techniques. However, some criteria, especially Galenson and Leibenstein maximising reinvestment surplus criterion, apply both to the choice of appropriate pattern of investment and appropriate choice of techniques, but the two should not be confused.

Present Consumption Vs Future Growth:

In planning for development a crucial choice has to be made between present consumption and future growth and consumption. Economic growth which is generally the objective of planning in developing countries requires acceleration of investment or capital formation. Capital formation is regarded as key to economic growth. However, higher rate of capital formation requires higher rate of saving which implies sacrifice of some present consumption for future growth of output and consumption. It may be noted that important measure of standard of living is the level of consumption per head of the population after making corrections for changes in the price level.

In view of the importance of economic growth for the future levels of output and consumption planners in developing countries are interested not merely in present consumption but also in its future level. One way of bringing future levels of consumption into the analysis of allocation of investment resources is to estimate the consumption levels in various future years from various patterns of investment and discount them at a certain specific rate of interest and then calculate the total discounted sum of consumption. Thus, the interest rate used for discounting future consumption levels depends on what weights the planners assign to the consumption in the present year, in the next year and the year after and so on.

Different interest rates of discounting present consumption and future consumption brings into the analysis the importance of time horizon in deciding about priorities in investment allocation which was emphasised by Amartya Sen in his important work ‘The Choice of Techniques’. Similarly, Maurice Dobb considers the choice between light and heavy industries as one of ‘time dimension of the investment’. “A given investment in light industries such as cloth making and food industries will increase the consumption in the near future but will restrict the rate of future development. On the other hand, investment in heavy industry like iron and steel and machine tool industries will quicken the pace of future development, though the immediate gains will be smaller”.

Present consumption vs future growth of output and consumption has been a matter of serious debate in connection with Mahalanobis growth model which formed the basis of the Second and Third Five Year Plans of India. Mahalanobis model gave a high priority to capital-intensive basic heavy industries such as iron and steel, fertilizers, machine tools and other capital goods industries) and lower priority to light consumer goods industries and agriculture.

As mentioned in quotation from Maurice Dobb above, in favour of basic heavy industries it was argued that though in the present they imply lower consumption level but as they bring about higher growth rate, in the future they will cause higher levels of output and consumption. Defending Mahalanobis, Dr. K.N. Raj writes, “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 accumulation) 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 here is stated as between investment in capital goods and investment in consumer goods industries”.

It is noteworthy that Galenson and Leibenstein in their proposed investment criteria, argued that, to maximise the rate of growth of output investment resources should be allocated to industries and projects that yield the maximum rate of surplus per worker. The surplus is difference between output and wages (Y-W) and they showed that the rate of surplus per worker employed is the maximum in capital-intensive industries and projects “which will bring about higher rate of economic growth and higher level of consumption over a long period time.”

Thus, according to them, some present consumption has to be sacrificed for having more consumption in future. However, in our view, this involves the relative evaluation of present and future consumption and on this will depend the choice of investment allocation among industries and projects. Amartya Sen has rightly pointed out that the choice of techniques and also of industries and projects must be evaluated with respect to a fixed time horizon acceptable to the society.

If in case of those capital intensive projects the actual time period it takes for the future growth in consumption to offset the loss of present consumption is less than that of the fixed time horizon acceptable to the society, then they may be preferred in allocation of investment resources with some sacrifice of present consumption. On the other hand, if the period over which the gains in welfare or consumption from capital-intensive projects just compensate the earlier losses in consumption exceeds the socially acceptable time horizon, then labour-intensive projects should be preferred over the capital-intensive projects.

However, though Sen’s time horizon analysis sounds theoretically valid, it is difficult to arrive at a socially acceptable time horizon in a democratic country. Referring to time-horizon approach to the choice of investment projects, Thirlwall rightly comments, “This approach is very arbitrary depending on the time horizon chosen. If, however, some democratic consensus can be reached, this would appear to be a better solution to the inevitable clash between present and future consumption than a straight choice between one or other of the investment criteria which in their basic form ignore the trade-off between present and future welfare.”

After the above general considerations relating to investment criteria, we shall discuss below a few criteria that can be adopted as the situation demands. For a planned growth we must explore suitable criteria for investment, i. e., to discover the main bases on which to determine the distribution of limited investible funds among the numerous competing industries or projects. We now turn to the discussion of some of the criteria that have been advocated by different authors.

Minimum Capital-Output Ratio Criterion:

The investment criterion that has often been advocated by some economists is that of capital-output ratio. That is, for choosing among investment projects and for determining priorities, capital-output ratios of different investment projects are compared. Those investment projects (or their technical forms) should be selected that minimize the capital-output ratio. If capital-output ratio of investment in projects A (3: 1) is less than the capital-output ratio of investment project B (5: 1), then, in developmental planning, investment project A must get priority over investment project B.

It may be noted that similar criterion known as ‘the highest rate of turnover criterion’ has been put forward by J.J. Polak and N.S. Buchanan. Rate of turnover means “ratio of output to capital investment” or simply output-capital ratio, that is, reverse of capital-output ratio. Under this the objective in the choice of allocation of investment is to maximise the rate of turnover, that is, maximize ∆O/I where ∆ indicates flow of output resulting from investment in a year.

Note that when rate turnover ratio (∆O/I) is maximum, capital-output ratio, which can be written as I/∆O, will be minimum.

Thus, when rate of turnover is maximised, capital-output ratio is minimised. Further, the rate of turnover indicates productivity of capital. Elaborating the highest rate of turnover criterion, Prof. N.S. Buchanan writes – “If investment funds are limited, the wise policy, in the absence of special considerations, would be to undertake first those investment having a high value of annual product relative to the investment,” that is, investment projects with a higher rate of turnover should be given preference. In other words, capital-output ratio is to be minimised in order to maximise ratio of output to capital investment.

The importance of lower capital-output ratio was brought out by Harrod-Domar model of growth according to which g =s/ν where g is rate of growth S is rate of saving [i.e., ratio of total saving (S) ν to national income (Y)] and v capital-output ratio.

According to this, the lower the rate of capital- output ratio, the higher the rate of growth. It was thought that one could also use the capital-output ratio as the basis for choice of investment projects in development planning and in this connection refinement in the capital-output ratio was made. A criterion for investment choice was made in terms of incremental capital-output ratio (ICOR). Incremental capital-output ratio implies marginal capital- output ratio. It was argued that those investment projects be chosen for which ICOR was lower.

The underlying assumption of this criterion is that projects in which capital investment is to be made are substitutes of each other. If every project is a substitute of every other, there is strong reason of preferring industries or projects with a lower marginal ratio of capital to net output. The classic case of substitutability is provided by the problem of choosing between alternative techniques to produce the same commodity.

Various examples can be given of it. Additional food-grains production can be obtained either from constructing major irrigation works or by building minor irrigation works or by producing and using more fertilizers. Electricity can be produced either by thermal projects or by hydel projects. Further, more cloth can be produced either in the small-scale industries sector or large-scale industries sector.

Critical Evaluation:

The capital-output ratio criteria have been subjected to several important criticisms. It suffers from all subject shortcomings of a static criterion which ignores the important factor of time dimension. It has been alleged that it is difficult to measure capital-output ratio or ICOR. The incremental capital- output ratio is generally measured by the investment divided by the flow of output from that investment over a year. But the lives of projects are different.

Some projects with a higher capital-output ratio go on yielding output for a longer time period, while the projects with a lower capital-output ratio has a shorter life time. Therefore, when time period over which projects go on yielding output in future is different it is difficult to make a choice. Attempt has been made to overcome this problem by finding out the present discounted value of output in future years of projects. However, what rate of discount rate is used for this purpose is a matter of controversy.

The minimum capital output ratio criterion suffers from another drawback. It is maintained that the economic world is not an abode of perfect or very high substitutability between various investment projects. For example, the allocation of investment between agriculture and industry or between consumption goods and investment goods cannot be adjudged on the basis of capital-output ratio, since the degree of substitutability between these products is very limited. Agricultural products and industrial products are complementary rather than substitutes.

Furthermore, it has been pointed out that some projects may have a higher productivity of capital than others, (that is, a lower capital-output ratio) because of the higher efficiency of cooperating factors used with capital, but there is no surety that these cooperating factors will be sufficiently available in the future. Thus, the projections of output from investment projects with lower capital-output ratios may not actually materialise due to the short supply of the cooperating factors used along with capital to produce output. Further, since the actual world is dynamic where technology is changing rapidly projects with lower capital-output ratios in the present may not remain so in the long run.

The important drawback of the minimum capital-output ratio is that choice of industries on this basis leads to the investment in light consumer goods industries such as cotton cloth, leather goods, food-processing industries (e.g., sugar) etc. which have lower capital-output ratio at the cost of basic heavy industries such as iron and steel, fertilizers, power generating projects, machine tool industries which have higher capital intensity.

However, as has been pointed out by Galenson and Leibenstein, the rate of investable surplus is lower in light consumer goods industries and therefore rate of growth of output in the long run will be lower if higher priority is assigned to them in the allocation of resources. It is noteworthy that Dr. K.N. Raj and Amartya Sen defended Mahalanobis strategy of giving higher priority to basic heavy industries arguing that it would ensure higher rate of growth in the long run which will lead to greater consumption in future. Thus, in India it has been strongly argued that what should be compared in choosing among investment projects are not their capital-output ratios, but their contribution to economic growth in future. The goal of developmental policy is not the maximum output at a point of time but a maximum rate of growth over time.

Furthermore, as has been rightly pointed out by Thirlwall that in the minimum capital-output criterion, “There is no explicit discussion either of how the flow of output should be measured at market prices or at prices adjusted to measure the social valuation of goods and factors of production. The concern with measuring costs and benefits from society’s point of view has led to the use of social marginal product while change in output is measured as the change in value added to society”.

Lastly, capital-output ratio may be one of the criteria when substitutes are involved, but is not the sole consideration. There are many other considerations too, such as the labour-investment ratio and the effect of investment allocation among projects on income distribution. In a developing country like India, where greater employment and better distribution of income and wealth are also the cherished goals of the Five Year Plans, these other considerations of investment projects are of paramount importance.

The Social Marginal Productivity (SMP) Criterion:

A more general criterion to guide -allocation of investment to different projects or industries is the social marginal productivity (SMP) criterion. It was put forward by A.E. Kahn and was further improved and extended by Hollis B Chenery. It is based on the conventional marginal productivity approach with a difference that it emphasises productivity of investment from a social point of view rather than from the viewpoint of private enterprise. According to A.E. Kahn, the allocation of limited investment resources among different industries or projects should be such as to ensure maximum social returns or national product, rather than achieving maximum return to the private investors.

The maximum national product will be achieved from the limited investment resources when marginal social product (SMP) of investment in different industries or projects are equalised. Kahn emphasises that marginal social product does not mean what an investment would yield to the private investor but what it contributes to the social or national product. To quote Kahn, “The correct criterion for obtaining the maximum return from limited resources is social marginal productivity, taking into account the total net contribution of marginal unit to national product, and not merely that portion of the contribution (or its costs) which may accrue to the private investor.” The private marginal productivity of investment can be written as –

MP = (R-C) / K

Where, MP is private marginal productivity of investment, R is the discounted stream of future returns, C is the discounted stream of future costs and K stands for capital funds. Now, in Kahn’s criterion social marginal productivity of investment is found by adding net external economies to the above private marginal product to obtain social marginal product.

Thus SMP = (R-C+E) / K……. (1)

Where, E is the discounted stream of future net external economies.

It may be noted that it is the addition of net externalities (E) that accounts for the difference between the private and social benefits. According to Kahn’s investment criterion for obtaining maximum social or national output, marginal social products (SMP) of investment in different industries or projects be equalised.

Extension and Improvement made by Chenery:

Chenery extended Kahn’s social marginal productivity criterion by including in it the impact of investment projects on the balance of payments to find the socially optimum investment pattern. Two aspects of his extension of Kahn’s criterion are noteworthy. First, it includes the ranking of different investment projects according to their effect on their national income, balance of payments and the costs of the domestic and imported materials used in production. The second aspect is the actual number of investment projects from which to choose. It will depend on the costs of projects and the availability of investment funds.

Given the above considerations, the social marginal productivity is obtained from the increase in the social value added (i.e., X + E) minus costs incurred on labour, materials (both domestic and imported) and overhead costs expressed as a ratio of total investment funds (AT). With this we write social marginal product (SMP) of investment as per Chenery’s criterion. Thus –

SMP = [X+E-(L+M+O)] / K…….. (2)

Where, X is increased market value of output and E is the addition to value of output due to net external economies, while L is labour costs, M is costs incurred in both domestic and imported materials and O is overhead costs and K is total capital investment made. Further, the combined X + E can be represented by V and the combined costs L + M + O can be written as C. With this social marginal product (SMP) in equation (3) can be written as –

SMP = (V-C) / K………… (3)

Now, an important contribution of Chenery has been to include the effect of investment projects on balance of payments. Some investment projects require imported materials for which foreign exchange is needed. Similarly, the products of the investment projects may be exported which earn foreign exchange. (X stands for national product and for external economies). Chenery adds the term B_r/K to the above Kahn’s measure of social marginal product (SMP) in equation (3) to show the impact of balance of payment on social marginal productivity (SMP) of an investment project. To do so we have-

SMP = [(V-C)/ K] + [(B_r/K)]…… (4)

If r equals zero, the term B_r/K will also be zero which implies balance of payments is in equilibrium and therefore demand for foreign exchange equals its supply. If r is positive it implies a surplus in balance of payments and if r is negative it means a deficit in balance of payments. Actually, r in Chenery’s formulation is taken to represent the investment in national income that could be considered as equivalent to one unit improvement in the balance of payments under the given conditions. It could, therefore, be regarded “as a premium attached to foreign exchange earnings or saving”. And it could be measured in terms of the average overvaluation of the national currency at the prevailing rate of exchange.

To sum up, according to this criterion, those investments should be made in which social marginal productivity is the highest. Those who advocate social marginal productivity as the main investment criterion have also deduced several corollaries as practical guides to investment policy.

Some of these are:

(1) A given volume of investment should be allocated in a manner that maximizes the ratio of current output to investment, i.e., capital-output ratio be minimized;

(2) Those investment projects should be selected that will maximize the ratio of labour to investment so as to maximise the growth of employment; and

(3) To reduce pressures on the balance of payments, investment should be allocated in a manner that will maximize the ratio of export goods to investment.

Merits of SMP Criterion:

Social marginal productivity criterion of investment is very useful as it shows the effect of investment projects on the total value of social product as compared to the marginal rule, that is, equating marginal productivities of investment in different projects which is based on profitability from the viewpoints of private investors. Further, as improved by Chenery social marginal productivity (SMP) criterion also incorporates the impact of investment projects on balance of payments which is highly significant as developing countries often face the balance of payments problem.

Furthermore, by considering the effects of external economies and diseconomies on the value of national product and costs, social marginal productivity criterion a significant part of social benefits and costs of various investment projects are taken into account.

Thus, the social marginal productivity criterion which aims to achieve maximum social returns from limited investment resources makes a significant improvement over the minimum capital-output ratio criterion. By including the effect of pattern investment on balance of payments, Chenery has made it very useful tool of project evaluation.

A Critical Evaluation:

Despite the merits of social marginal productivity criterion, its application in actual world is, however, likely to be difficult. This is because development is a dynamic process which involves change in the size and quality of population, tastes and pattern of demand, technological knowledge and social and institutional factors. The criterion of social marginal productivity must therefore be interpreted within the total dynamic complex. To do this, one must make value judgments regarding the various social objectives, some of which can be conflicting.

Suppose an economy is at a stage when investment in agriculture is likely to be most productive and will provide maximum employment to rural labour. Even then it does not follow that priority to investment in agriculture is decided forever. This is because, as the economy grows, in accordance with Engel’s law of consumption, the demand for industrial products increases relativity to food-grains and to meet this demand allocation of investment resources has to be raised. With further growth, the demand for services increases relatively more as compared to the demands for agricultural and industrial goods. This calls for higher allocation of resources to services.

Secondly, different patterns of investment are likely to result in different distribution of income. But by not incorporating in the SMP criterion, the effects of investment on income distribution, Chenery ignores a very important aspect of economic development. Investment affects welfare not only through the economic growth it achieves but also how it affects income distribution in a society.

For example, if a pattern of investment chosen on the basis of SMP criterion maximises total output or income but at the same time involves a more unequal distribution of income than would another project do, should it be preferred? Answers to questions like this involve value judgments and different individuals may reach different conclusions. The social marginal productivity of project will alone not be a sufficient guide to investment.

Like the capital-output criterion, the social marginal productivity criterion is also ambiguous as a guide to social investment decisions, when the shape of income stream over time is considered. To determine the most productive investment projects, future yields of capital assets must be discounted to their present values, and these discounted values compared with their present costs. Investment decisions will differ according to the shape of the future income stream which is desired. For instance, from the standpoint of having a maximum increase in national output during the next five years, one type of investment, say, cotton textile production, might be the best.

From the standpoint of having the highest national output 15 years hence, investment in some other direction, say steel production, might be better. Conflicting conclusions will also emerge if we want to maximise level of consumption over different periods of time, say immediately or later. One project may raise consumption level in the short run and another proves to be more fruitful in this direction in the long run. It is therefore not easy to decide which project to choose. Even though there is an agreement on a general principle, it will be difficult to take an investment decision in actual practice, in a dynamic world.

Further, the SMP criterion evaluates various investment projects independent of one another, and ignores the structural linkages among various investment projects through supply of inputs and sale of output. For appropriate and consistent resource allocation requires input-output analysis which takes into account these linkages between various industries. But these linkages between industries do not find any place in SMP criterion.

In this connection special mention may be made of lack of infrastructures facilities in the fields of power, transport, communication (especially telecommunication), roads and highways, iron and steel which serve as a constraint on the growth of other industries and therefore by not taking into account the important linkage of investment in various industries with adequate investment in the growth of infrastructural facilities SMP criterion cannot ensure rapid and sustained growth of gross national product (GDP). Thus one should evaluate not a particular investment project but a package of projects if SMP criterion is to ensure appropriate pattern of investment.