CHAPTER TWO:

ALLOCATION OF RESOURCES: INVESTMENT

CRITERIA

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The need for investment criteria in LDCs
In the traditional static economic theory, allocation of resources

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is regarded as optimal or efficient when any transfer of resources
between different sectors will not raise real national income any
further.
The principle to obtain such a point of optimality is to equate
marginal productivities of different inputs in alternative
activities.
For example, the different markets (product, labour, money
etc.) in the LDCs are so imperfect that the market prices of
resources, i.e. wages and interest, do not reflect their true social 1
opportunity costs.
 THE NEED FOR INVESTMENT CRITERIA IN LDC CONT.…

 Thus, market prices may give wrong ‘signals’ for

allocating resources and, given the divergences between

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the marginal private net benefits (net of costs) and
marginal social net benefits (net of costs), the use of

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marginal principles will result in misallocation of
resources.
 Second, the LDCs may not be interested in the static
principles of resource allocation. Given these principles,
the LDCs may wish to maximize immediate rather than
future output and consumption. But this may not lead to
the attainment of a future optimal level. .
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 CONT..
 Third, it is normal in the application of the static principles that
the existing distribution of income is assumed to be optimal and

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remains unaltered by the choice of development strategy.
 Fourth, the question of externalities in many sectors could well
lead to divergences between social and private costs.

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 Problems of investment criteria in LDCs are also related to
macro and micro level decision-making processes.
 The debate among the different schools advocating different
investment criteria has generally centered round the question of
allocating scarce inputs in the LDCs

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THE CAPITAL TURNOVER CRITERION
 The problems of investment strategies in most LDCs
center round the choice of values of the different

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variables of the Harrod-Domar growth model to
maximize growth rates.
 Assuming that S is the saving income ratio(amount of

saving divided by income s/y) and C is the capital-output

ratio( amount of capital required to produce a single unit of output k/y), the
Harrod-Domar model states that g=S/C where g is the
rate of growth of output.
 It is obvious from this equation that to raise the growth
rate we are required either to raise S or to lower the
value of C. 4
 CONT..
 Given such policy options, Polak (1943) and

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Buchanan (1945) argued that given the scarcity of
capital in LDCs the Harrodian C should be
minimized.

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 This is known as the capital turnover criterion.

 According to Polak and Buchanan, those investment

projects should be chosen which have a low C, i.e. a
high rate of capital turnover.

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 ARGUMENT

1. Given some capital scarcity in LDCs, a high capital turnover

criterion would lead to an efficient allocation of resources.

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2. Since the rate of population growth and sometimes the size of
the population are very high, the supply of labour in most cases is
greater than demand, particularly in unskilled work. The choice of

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the capital turnover criterion would lead to the adoption of labor-
intensive techniques of production and this would help to alleviate
the problem of unemployment.
3. Since many LDCs suffer from a balance of payments constraint
because of their high demand to import modern technology from
the developed countries, the use of the capital turnover criterion
will reduce such demand and ease the pressure on foreign
exchange.
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ARGUMENT

1. The use of this criterion ignores the externalities arising

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out of investments. Given the complementarities of
different projects, a project which involves a higher capital-

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output ratio need not be assigned always a lower priority.
2. The time element plays a crucial role because quick-
yielding projects with a lower capital-output ratio in the
short run do not necessarily have a lower ratio in the long
run.

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CONT..

3. In some projects, particularly within the agricultural

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sector in LDCs, fixed capital may form a small proportion
of total inputs of working capital. The fixed capital-output

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ratio may fluctuate substantially because of factors other
than capital investment.
4. The use of the capital turnover criterion may go against
the objective of maximizing the rate of economic growth
if resources such as skill and management are scarce.

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THE SOCIAL MARGINAL PRODUCTIVITY
CRITERION
 In allocating investment, it is necessary to consider the
total net contribution of the marginal unit of investment

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to national output (i.e. the social marginal productivity
(SMP)) .

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 Efficient allocation consists of maximizing the value of
national product and the principle to obtain this objective
is to equate the SMP of capital in different uses.
 Where the social opportunity cost of labour is zero there
is no difference between the capital turnover criterion
and the SMP criterion.

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CONT..

 This has been given by Prof. Kahn. According to him,

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“The correct criterion for obtaining the maximum return
from limited resources is marginal productivity or from

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the point of view of society as a whole, social marginal
productivity.”
 According to this criteria investment should be made in
such projects in which social marginal productivity is the
highest.

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 CONT..
 More formally the SMP criterion may be defined as
follows:

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SMP = V/K – C/K .
 where V is the annual value of total output, C is the

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total annual cost of amortization and K is total
investment.
 To adjust for the total net effect on the balance of
payments (B), the above equation can be rewritten as:
SMP = V/K – C/K + VB/K
 where VB is the variation in income because of a
change of one unit in the balance of payments.
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 MAJOR CRITICISMS OF THE SMP PRINCIPLE .

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1. The SMP principle ignores the multiplier effects on future income levels.
2. The SMP criterion does not make due allowance for the changes in the nature
and quality of factors of production such as population and labour that may

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take place as a result of present investment.
3. In the labour-surplus economies where the opportunity cost of labour may be
zero, the SMP criterion is open to the same criticisms as can be levelled
against the capital turnover criterion.
 Until now we have been discussing the main strengths and weaknesses of the
arguments which are advanced to the theory of maximizing current national
income.
 We turn next to discussion of the theory which aims at maximizing future rates
of growth.
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 THE MAXIMIZATION OF THE RATE OF
CREATION OF INVESTIBLE SURPLUS PRINCIPLE
 The maximization of the rate of creation of investible surplus
(MRIS) criterion is chiefly advocated by Galenson and

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Leibenstein (1955).
 Their main objective is to maximize per capita real income at a

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future point of time. Galenson and Leibenstein emphasize the
role of capital accumulation to achieve a higher rate of growth.
 Their main argument rests on the following premises.

First, national income can be divided into two parts: wages and
profits.
Second, wage earners savings are zero but profit earners total
income is available for investment.
Third, one production function, which makes output per unit of
labour a function of capital per unit of labour, prevails in the 13
whole economy.
EVALUATION OF THE MRIS CRITERION
1. Per capita real income maximization at some
future point of time has not been considered as a

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very realistic goal (Eckstein 1957).
2. There is not enough evidence to assume that the

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propensity of the workers to save will be zero and
that of the profit earners will be equal to one.
3. Maximum use of capital in some projects may
well reduce the rate of profit particularly where we
do not assume that production is the same function
of capital for all sectors.

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 CONT..

4. In labour-surplus economies as well as in LDCs

characterized by large unemployment and

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underemployment, maximization of employment may
well be a social and political objective (Brahmananda
and Vakil 1956). Realization of such an aim may well

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call for the use of the capital turnover rather than the
MRIS principle.
5. Many LDCs do not have markets large enough to
support capital-intensive industry on an economic basis.
6. Unless a balance is struck between increases in
production of capital goods and of consumer goods,
supply inelasticities in the production of consumer goods
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could lead to inflation.
 BALANCED AND UNBALANCED GROWTH

 A lively debate has taken place between the advocates

of balanced and unbalanced growth as strategies for

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economic development in the 1950s and 1960s.
 Here we shall first analyse the arguments of the proponents of

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balanced growth (BG) and this will be followed by analysis of
the theory of unbalanced growth (UBG).
 In conclusion it will be argued that the two theories instead of
being substitutes are really complementary to one another.
 As one of the main champions of BG, it was Rosenstein-Rodan
(1943) who was the first to point out the need to achieve
growth by a ‘big-push’ in east and southeast Europe.

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 CONT..
 The bottlenecks on the demand side imposed by the narrow
size of the markets could be removed if a number of industries

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could be set up simultaneously, each catering for the other.
 Lewis (1955) has argued for BG mainly because he wanted to

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avoid excess capacities and waste. He has pointed out the need
to maintain the terms of trade constant between different
sectors so that the growth of any sector need not be adversely
affected by an adverse movement of the terms of trade against
it.
 Lewis has emphasized the vertical nature of production of the
supply side while RosensteinRodan and Nurkse have
emphasized the horizontal interdependence of consumption
(Mathur 1966).
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THE ARGUMENTS AGAINST BALANCED GROWTH
 Fleming (1955) has pointed out that if most industries expand at
the same time, then assuming fixity of supply of factors and

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their full employment, inflation would take place.

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 Bauer and Yamey (1957) have also criticized the doctrine of BG
on the grounds that it unrealistically assumes that the supply of
food is elastic.
 Bauer and Yamey have also argued that ‘any industry which is
able to compete in the export market would be established
independently of the schemes of balanced industrialization’.
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THEORY
 The case for UBG, according to its champions, rests
primarily on the necessity to economize on the use of

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resources.
 For example, it is argued that since most LDCs

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experience a shortage of entrepreneurs, it is very
difficult for them to attain BG (Bauer and Yamey 1957;
Kindleberger 1956)
 Next it is argued that growth should take place through
shortages and excesses as it is assumed that every
challenge would generate its own response.
 This is very much like the operation of Say’s law in
reverse: that demand creates its own supply. 19
 CONT..
 It has also been argued that BG would require

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planning and most LDCs do not have either the
required skill or the necessary reliable and adequate
information to formulate such plans. Moreover,

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planning may involve huge costs in real terms.
 Further, given the scarcity of resources in LDCs, all
waste or external diseconomies should be minimized
as far as possible.

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 RECONCILIATION BETWEEN BG AND UBG
THEORIES
 It is possible to suggest that the two theories, instead of being
substitutes, are really complementary to one another. This is

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clearly reflected in the statement of Streeten (1959): choose
projects which,

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(i) while advancing some sectors, concentrating the pressure or
unbalance on groups and sectors whose response to a challenge is
likely to be strongest;
(ii) while creating bottlenecks also break them;

(iii)while providing products and services for industry, agriculture and

consumers, also induce new developments to take place in other
directions, directly and indirectly related to them;
(iv)while providing a new product or service require consequential
investment in other lines.
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22
QUESTIONS