Chapter No.80

INTRODUCTION

The problem of investment criteria involves the principles underlying the allocation of scarceinvestment resources in a rational manner so as to maximise the national income in anunderdeveloped economy. It is a commonly known fact that private enterprise in such economiesis motivated by profit maximisation. Very often private investment decisions are for projectsthat are not conducive to economic development. It is, therefore, felt that only a public authoritycan make decisions to allocate scarce investment resources and to influence the direction ofprivate investment towards development-oriented projects. For this, the choice before the publicauthorities is between techniques of a higher or lower capital intensity. Towards this end,economists have propounded a number of investment criteria which are discussed below.

THE CAPITAL-TURNOVER CRITERION

The capital turnover criterion is known by various names viz., the rate of turnover criterion, themaximisation of output per unit of capital criterion or the ratio of output to capital criterion(minimum capital intensity or minimum capital-output ratio criterion). This criterion is attributed

1. This appeared as an article in a slightly modified form in AICC Economic Review, January 1969. Publishedwith the kind permission of the Editor.

C H A P T E RC H A P T E RC H A P T E RC H A P T E RC H A P T E R

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to J.J. Polak and N.S. Buchanan.2 The logic involved is that since capital is scarce inunderdeveloped countries, that technique should be chosen which yields the maximum outputper unit of capital employed. In other words, for maximising output, investment projects witha high rate of capital turnover (i.e., of a low capital output ratio) should be selected. Quick-yielding projects with a low capital intensity make it possible for scarce capital resources to berealized soon enough for reinvestment into other projects. Such projects also provide maximumemployment per resource in underdeveloped countries. Here the capital employment absorptioncriterion merges into the capital turnover criterion.3 This criterion is particularly useful, accordingto Chenery, in choosing among projects within a given sector.Its Limitations. There are, however, certain limitations of this criterion.First, it ignores the element of time. Quick-yielding projects having a low capital-output ratioin the short run may have a high ratio in the long run.4

Secondly, this criterion ignores the supplementary benefits flowing from an investment project.It is possible that projects with a high capital-output ratio may confer certain supplementarybenefits on the economy thereby outweighing extra costs involved in them. On this count, notesa UN study, a project with a high capital-output ratio should not necessarily be accorded alower priority.5

Thirdly, in certain industries like agriculture, a low capital-output ratio may appear outwardly.If working capital like fertilisers is also included in the fixed capital investment, the ratio mayin fact be high.Fourthly, the higher the rate of turnover, the higher may be the rate of depreciation of capitaland rate of output may hot be high. Therefore. Dr. K.N. Prasad suggests the net rate of turnovercriterion instead.6

Fifthly, the maximisation of employment argument implied in this concept may hold good onlyin the short run. A capital-intensive project may absorb little labour to start with, but maymaximise the amount of labour per unit of investment in the long run.Sixthly, it does not necessarily follow that with increased employment there will be an additionto total output. Labour-intensive and capital-saving investments may keep productivity of labourlow as usual, without making any addition to total output.Seventhly, the use of labour-intensive techniques may even reduce output thus necessitating agreater use of capital thereby raising the capital-output ratio.Lastly, such techniques often produce sub-standard products. Such products are often subsidisedby the government and entail high social costs, e.g., the production of cotton textiles withhandlooms.Conclusion. The capital turnover criterion is thus circumscribed by a number of factors. Nodoubt common sense demands that in the face of abundant labour and scarce capital inunderdeveloped economies projects of a low capital intensity should be undertaken but theundeniable fact remains that for building up the socio-economic infrastructure and for

2. J.J. Polak, Balance of Payments Problems of Countries Reconstructing with the help of foreign Loans.”Quarterly Journal of Economics, February 1943 and N.S. Buchanan, International and Domestic Welfare,New York, 1945.

3. Nurkse’s doctrine of Concealed Saving Potential is a variant of the Capital Absorption Criterion,R. Nurkse, Problems of Capital Formation in Underdeveloped Countries. Ch. II.

4. Merits of a high capital-output ratio are discussed in detail above.5. UN, Economic Bulletin for Asia and Far East, June, 1961, pp. 30-33.6. K.N. Prasad, Technological Choice Under Development Planning, 1963.

632 The Economics of Development and Planning

accelerating the rate of economic development, project with a high capital intensity are also amust. India has been judiciously following this dual investment policy in her plans for economicdevelopment.

THE SOCIAL MARGINAL PRODUCTIVITY CRITERION

The social marginal productivity (SMP) criterion was first put forward by A.E. Kahn and laterHollis B. Chenery7 improved upon it. It is based on the conventional marginal productivityapproach. As more and more capital is employed in any project in combination with givenamounts of other inputs, its marginal product will after a time start falling till the marginalproductivity of capital in different uses is equalised. The aim is to allocate limited investmentresources in such a way as to maximise the national output. In other words, they should beutilised in the most productive projects. Kahn states that this criterion takes “into account thetotal net contribution of the marginal unit to national product and not merely that portion ofcontribution (or of its costs) which may accrue to the private investor.” Thus it is applicable tothe economy as a whole and not to individual investment projects.Chenery evolves a formula for the quantitative measurement of the SMP concept. He ranksinvestment projects according to their social value and studies their effects on national income,balance of payments and the cost of domestic and imported materials used therein. The selectionof projects depends on their rank, and their number on their cost and funds at their disposal.Taking the balance of payments to be in equilibrium, the Chenery equation is:

SMP = + − − −X E L M O

Kwhere, X represents increased market value of the output, E the added value of output due toexternal net economies, L cost of labour, M cost of materials, O overhead costs includingdepreciation, and K is capital funds invested. The equation can be simplified as (V–C)/K where,V the social value added domestically equals (X+E) and C the total cost of factors equals (L+M+O).Since in underdeveloped countries foreign exchange is more valuable than domestic currency,there is a large difference between the actual and official value of the foreign currency in termsof the local currency. Chenery represents this difference by r. A zero r means equilibrium in thebalance of payments, a positive r represents a surplus and a negative r, a deficit in the balance ofpayments of the country. Accordingly, the refined formulation is:

SMP = − + +V C

K

r aB B

K

( )1 2

The other elements being the same, aB1 is the annual authorised impact on the balance ofpayments of servicing initial borrowings from abroad and B2 the annual effect of the project’soperation on the balance of payments. If B is negative, it means an import and if it is positive itis an export. To simplify the formula still further r (aB1+B2) is represented by Br, the combinedbalance of payments effect and the final formula is:

SMP = − +V C

K

Br

K

7. A.E. Kahn, “Investment Criteria in Development Programmes.” Quarterly Journal of Economics, February,1951, pp. 38-61 and Chenery, “The Application of Investment Criteria,” Quarterly Journal of Economics,February, 1963, pp. 76-96.

Investment Criteria in Economic Development 633

With the help of this formula Chenery has calculated the SMP of a number of investment projectsin Italy and Greece. According to him the use of this formula in full may help in improvingupon the method of using funds in a piecemeal manner on major projects.Its Limitations. Despite this, the practical usefulness of the SMP criterion is limited due to anumber of considerations.First, it is not correct to say that the marginal productivity of capital is exactly equal in all uses.It can be at the most nearly equal, for investment may be either too large or too small due totechnical reasons.Secondly, marginal productivity of capital in the case of different projects is equalised on thebasis of a particular technology which may not necessitate the reallocation of investible funds.But it might be useful to devote larger doses of capital to particular projects if it leads to the useof a better technology.Thirdly, the SMP criterion considers only the effects of the present. Factor productivity in differentuses depends on the relationship between costs and prices of the products produced and thesein turn depend upon supply and demand conditions. In the short run, resources are adjusted toprevailing supply and demand conditions, while in the long run they are themselves influencedby present investments. Similarly, cost conditions may also be changed over time with theacquisition of more knowledge, skill and experience by entrepreneur and workers. Thus, it isdifficult to calculate the productivity of resources when the time period is long.Fourthly, the SMP criterion is vague and indefinite. For it is difficult to have a correct assessmentof the benefits and costs of different projects both in the present and future. Market prices arenot a correct guide to resource allocation. There is wide disparity in underdeveloped countriesbetween the equilibrium and the market rates of interest, wages and foreign exchange. Likewisethe benefits accruing from social investments like education and public health services can atbest be assigned arbitrary monetary valuations. There are also idle resources like theunderemployed and the unemployed manpower whose market value is not capable ofmeasurement. Chenery himself admits that such imperfections in the market forces will “ greatlyreduce the social value of investment unless an attempt is made to offset them.” Therefore, tofacilitate the calculation of social values in these and other cases, Chenery, Frisch and Tinbergenhave suggested the use of “shadow” or “accounting” prices reflecting the intrinsic value ofproducts and factors. Corresponding to the concept of shadow prices is the concept of “shadowcost” which is used to calculate the cost of a particular project to society. An ILO study suggeststhat these shadow prices and costs and not the market prices and costs, if any, should be used inranking investment projects and determining which are worth undertaking and which are not.8

Finally, one of the major defects of the SMP criterion is that it is concerned with once-for-alleffect of investment on the national income and neglects the multiplier effect of presentinvestment on future income. Moreover, it does not consider the indirect effect of the presentinvestment on population, saving and consumption in future.9 It is possible that the presentinvestment may increase the national income but may make the distribution of income unequal.Similarly, investment in some projects may raise the per capita consumption in the present ascompared with other projects which may raise it over the long period. Therefore, the SMPcriterion is at best a value concept.

8. Some Aspects of Investment Policy in Underdeveloped Countries,’ International Labour Review, May1958.

9. UN, Economic Bulletin for Asia and Far East, June 1961, op. cit.


THE REINVESTMENT CRITERION

The reinvestment criterion is advanced by Galenson and Leibenstein.10 It is also known as therate of surplus criterion or the marginal per capita investment quotient. The latter is defined asthe “net productivity per worker minus consumption per worker.” Galenson and Leibensteinemphasize the maximisation of per capita output in future rather than in the present. This ispossible when the rate of savings is maximised leading to reinvestment of income. Assumingthat national income is divided into wages and profits, the former are spent on consumptionand the latter are saved for the purpose of investment. The larger the volume of profits, thehigher will be rate of savings, as a result the larger will be the amount of capital available perhead and the higher will be the growth rate of output which will lead to increased output perhead in future. In the early phase of development a “critical minimum effort” is required on thepart of underdeveloped countries to increase the proportion of profits to national income andto restrict consumption per head. This would lead to larger savings and larger reinvestiblesurplus. Given the quality and quantity of labour force, it is the capital-labour ratio thatdetermines per capita output. Galenson and Leibenstein use the following formula to determinethe rate of investible surplus (r)

rp e w

c= − . .

where, p is the product per machine, e the number of men per machine, w real wage rate, and cthe cost of machine, r can be increased by raising p and depressing e.w in proportion to c.In order to raise the proportion of capital to labour, the per capita output potential and the percapita investible surplus, Galenson and Leibenstein favour capital intensive techniques even inthose countries were capital is scarce and labourabundant. Production processes having a highratio of capital to labour result in a large shareof income going into profits and a small shareinto wages. Thus a large proportion of the initialincome is available for investment through profits.The larger the profits, the higher will be thesavings. As a result, more capital will be availablefor investment and the greater will be the increasein output. This is illustrated in Fig. 1 whereinthe north-east quadrant the relationship betweennew investment and resulting changes inemployment N is represented. Nk shows thisrelationship when a capital intensive techniqueis used, and NL when a labour-intensive technique is used. The north-west quadrant representsthe relationship between employment and output. OK shows this relationship with a capital-intensive technique, and OL when a labour-intensive technique is used. Assuming the sameamount of new investment OI, the capital-intensive technique creates IB employment whilethe labour-intensive technique creates IC employment. But the labour-intensive technique creates

IE OD

Nk

B

N

OK

NLO

L

Output

C

InvestmentFig. 1

Em

ploy

men

t

10. W. Galenson and H. Leibenstein, “Investment Criteria, Productivity and Economic Development,”Quarterly Journal of Economics, August 1955, pp. 342-70. Also H. Leibenstein, Economic Backwardnessand Economic Development, Ch. XI and comments by H. Neissen, J. Moses and A. Hirschman inNovember 1965, 1 February, 1957 and August 1968 issues respectively of the Quarterly Journal ofEconomics.


only OD output while the capital-intensive technique creates larger output OE. Thus the capital-intensive technique creates less employment but more output while the labour-intensivetechnique creates more employment but less output.Urbanisation following industrialization through the establishment of capital-intensiveindustries will affect a number of other social and economic factors including population growth.Further, capital-intensive production processes imply a long life of capital goods. Therefore, asmaller proportion of the gross investment resources will be required for replacement of wornout capital goods and a larger proportion is available for future capital formation. Anotherimportant argument in favour of such techniques is that though they absorb less labour in theshort run, yet they are capable of absorbing more labour in the future as the growth rate will befaster in the long run.Its Criticism. There are, however, certain objections to this criterion:First, the reinvestment quotient is based on the assumption that consumption remains constantovertime. But this is untenable. For as pointed by A.K. Sen, with additional employment the totalconsumption of the community is likely to increase and unless the increase in output as a resultof additional employment is greater than the increase in consumption resulting from it, thevolume of investible surplus will fall. This will adversely effect the growth rate of the economy.11

Secondly, this criterion rests on the assumption that whatever is received as wages is spent onconsumption and whatever is not paid to labour is reinvested. In fact, there are likely to beleakages in the wage-stream and profit-stream flowing into consumption and investmentchannels respectively. With the increase in real total output, workers might feel better off thanbefore even at the same wage rate and may save something. The doctrine makes no allowancefor capital depreciation either, which is sure to reduce the reinvestible surplus. Thus, the authorsfail to discuss the problems which may ensure wages to be spent exclusively on consumptionand thereafter the surplus to be reinvested.Thirdly, it goes against the principle of marginal productivity of capital. As the amount of capitalis increased in successive doses after a point its productivity starts declining. This implies a fallin output per capita and in the reinvestment quotient.Fourthly, the contention that highly capital-intensive processes have a large reinvestment potentialdoes not appear to be correct. A highly capital-intensive industry like the iron and steel will notyield output until several years have elapsed. On the other hand, modern small enterprisespossess a high reinvestment coefficient and thus use more capital and more labour per unit ofoutput than large factories.12

Fifthly, the concentration upon large scale capital-intensive industries is beset with a number ofpractical difficulties in underdeveloped countries. Due to lack of skilled labour andentrepreneurial ability, the efficient management of large undertakings is difficult. Further,due to non-availability of sufficient capital for small enterprises, consumer goods industriesare unable to develop, thereby leading to inflationary pressures in the economy.Sixthly, the investment criterion is lopsided, for it does not study the effect of balance of paymentson investment. In an underdeveloped economy there is an acute scarcity of capital goods whichhave to be imported and they worsen the already tight balance of payments position.Seventhly, Otto Eckestein is of the view that instead of depending on the reinvestment criterionfor planned investment, it may be better to use fiscal measures to attain an income distribution

11. A.K. Sen, “Some Notes on the Choice of Capital Intensity in Development Planning,” Quarterly Journalof Economics, November, 1967.

12. P.N. Dhar and H.F. Lydall, op. cit.13. O. Eckestein, “Investment Criteria for Economic Development and the Theory of Inter temporal Welfare

Economics.” Quarterly Journal of Economics, February, 1957.


which will yield sufficient savings for the purpose of investment.Eighthly, the reinvestment criterion neglects the importance of consumption, rather it advocatesits curtailment. But current consumption may be more important than future consumptionand the reinvestible surplus may have to be cut down in the interest of the community.13

Neglecting the consumer goods sector in favour of the capital goods sector is wrought withserious consequences both for the economy and for the state. It is bound to lead to scarcity ofessential commodities and to inflation and social unrest in an underdeveloped economy weddedto democracy.Ninthly, the use of the reinvestment criterion perpetuates the problem of unequal distributionof income in such economies. There is a greater degree of unequal distribution of income betweenthe wage earners and the capitalists and between those who obtain immediate employmentand those who are left unabsorbed.14

Lastly, this criterion does not reckon those cases of development planning in which the presentincome is valued more than the future income for facilitating the expansion of the capital goodssector and in which a lower growth rate but a higher rate of income in the immediate future isto be preferred.15

Conclusion. Despite these limitations, the reinvestment criterion is useful as a firstapproximation towards accelerating the rate of income growth in an underdeveloped economy.It is more realistic than the social marginal productivity criterion, for it takes into considerationthe effects of population growth on the rate of investment in future.

THE TIME SERIES CRITERION

A.K. Sen has put forward the “time series” criterion.16 The criterion seeks to maximise outputwithin a given period of time. Given the capital-output ratio and the rate of savings, the time-

Table 1 : Time Series

Project I Project IIPeriod (Capital-intensive) (Labour-intensive)(in year) H L

(Returns in millions) (Returns in millions)

1 4.0 6.02 . 5.0 7.03 6.0 8.04 7.5 9.0 (b)5 9.0 10.06 10.5 11.07 12.0 11.58 13.5 12.09 15.0 (a) 12.510 17.5 13.0

100.0 100.0

(a) excess over L 58.0 - 49.0 = 9.0(b) excess over H 51.0 - 42.0 = 9.0

14. H.Myint, The Economics of Developing Countries, 1967, p. 139.15. K.N. Prasad, op. cit.16. A.K Sen, “Some Notes on the Choice of Capital Intensity in Development Planning.” Quarterly Journal

of Economics, November, 1967. Also his book Choice of Techniques., Ch. II, V, VII and VIII.


path of (say) two techniques (capital-intensive and labour-intensive) can be drawn and it can befound out which of the techniques yields the highest returns over the time-horizon. Supposethat there are two projects H (capital-intensive) and L (labour-intensive) and time horizon is tenyears, at the end of which total returns in each case are 100 million. This is shown in Table 1.

The returns of the H project are less (42 million) in comparison to those of the project L (51million) over the first six years while in the remaining four years the returns of the H projectrise more than that of the L project. The returns rise from 42mto 58m in the case of project H and fall from 51m to 49m inproject L. Since the total returns are the same (i.e., 100 million)from both the projects, the overall position is one of indifference.The important point is as to whether the initial loss in outputby adopting a capital-intensive project is recovered within thetime period of ten years or not. The time taken by the capital-intensive technique to overcome its initial deficiency in outputover the labour-intensive technique is called by Sen “the periodof recovery”. This is explained with the help of the diagramabove reproduced from Sen.[H and L curves show the flow of real output during a given time horizonwith two techniques. Technique H (see Table 1) gives lower output in thebeginning but a higher rate of growth than technique L. Up to the timeperiod D, technique L gives more output over technique H. At the point oftime R, technique H makes up this deficiencey when it give CBC1 more output over technique L. The period ORis the period of recovery which makes the area ABA1 = CBCt area].

Thus for any pair of techniques a period of recovery can be found out. In choosing between thetechniques the period of recovery should be compared with the period we are ready to takeinto account. If it is found that the period of recovery is longer, that is, if within the time-horizon, the loss in output, by adopting technique H is not recovered by the excess of output weshould choose technique L. If reverse is the case, technique H may be chosen. To the extent realwages are within control and the taxation system is capable of providing any rate of saving, thequantitative importance of the conflict between the maximisation of immediate output and thefuture growth rate is less. But so long as there is some conflict between the present and thefuture, the choice will depend on the time discounted use. To say, therefore, according to Prof.Sen, “that over-populated countries should always prefer labour-intensive methods concealsan implicit preference for present over future, and represents a very short planning horizon.On the longer planning horizon, the more we calculate the future rate of growth over the presentlevel of consumption and employment, the more we should favour capital intensive methodswhich are capable of yielding a larger surplus of output over, wage costs for a given capitaloutlay and so make possible a higher rate of reinvestment for the future.”This criterion by taking into consideration the element of time for determining productiontechniques in an underdeveloped economy becomes more realistic than the other criteriadiscussed above.Its Limitations. But Sen himself points out three limitations of his concept:First, the taking up of a particular time-horizon, say of ten years, is arbitrary.Secondly, it is not possible to derive the time series for all times to come. Therefore, the planningperiod has to be definitely fixed. But this creates some serious problems. When the time limit isabout to end, labour-intensive technique might be selected in order to inflate the quality of

D

L

O R

C

H

B

A

C1

A1

TimeFig. 2

Out

put


output and thus capital formation is neglected. As a result, investment will fructify after thetime limit and it might not be possible to compensate for the depreciation of machinery.Thirdly, factors like technological change, wage rate, propensity to consume, etc., on which thestudy of time series depends may all be changing and make the forecasting of future investmentand output not only difficult but also erroneous.Lastly, Prof. Prasad is, however, of the view that there is nothing novel about this criterion. Ifthe period of recovery is very short, this criterion in practice becomes the net rate of turnovercriterion and if the period of recovery is very long, it corresponds to the reinvestment criterion.In the end we are left with the question, what criterion is there for the choice of a time period?”17

CONCLUSION

The various investment criteria discussed above are not different in their ultimate objective,that of the maximisation of national output. Only the approach routes differ. The differentcomponents of national income (consumption, saving and investment) are used by economiststo maximise the total output by giving more or less importance to one or the other. Someinvestment criteria aim at maximising total output at a point of time while others over a periodof time. But all criteria are incomplete because they neglect the influence of such factors aspopulation growth, tastes, technical progress, market conditions, distribution of income, pricechanges, balance of payments and social and cultural conditions on the level of investment inone way or the other. Contrarywise, they also fail to study the impact of investment on thesefactors. Even the use of input-output technique and the concept of shadow prices and costshave failed to solve this problem satisfactorily. But despite these apparent theoretical and practicallimitations, the various investment criteria are being increasingly made use of in theprogramming of resource allocation in almost all the developing countries of world includingIndia. It is, however, essential that they must be in keeping with the social and economic objectivesof the developing country.

17. K.N. Prasad, op. cit.

Chapter No.80

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