The choice of techniques is an area of economics in which the question of the appropriate capital or labor-intensity of the method of production of goods is discussed. In the context of traditional development economics it was often recognized (Stewart (1972) for example) that this choice was central to development strategies and that such choices were inter-twined with decisions over the type of goods to be produced and the scale of operation of an industry.

CHOICE OF TECHNIQUES, INVESTMENT CRITERIA AND SOCIAL APPRAISAL OF PROJECTS

EFFICIENT OR “OPTIMUM” INPUT COMBINATION

The technique that maximises profit, given the relative prices of factors is regarded as the most optimal.

CAPITAL

A

M T

I

N B

LABOUR Figure 1: Optimum Input Combination

The isoquant I represents the different methods of producing the same output (in terms of capital/labour ratios).

Factor availability is represented by the price-line AB.

The optimum input combination is shown at the point of tangency T.

THE CAPITAL INTENSITY OF TECHNIQUES IN DEVELOPING COUNTRIES

THEORY:

In situations of surplus labour and scarce capital, labour-intensive techniques will be chosen.

CAPITAL I DC

a

c LDC

I

2

O d b LABOUR

Figure 2: Optimum Technical Choice in Developed and Less Developed Countries (LDCs)

In the LDCs, the optimum K/L ratio is given by the ray, LDC;

While in the developed country, the optimum capital-labour ratio is given by the ray, DC.

PRACTICE:

The capital-intensity of techniques is not very different between developed and developing countries.

In the modern sector, in LDCs techniques are much more capital-intensive than would be predicted on the basis of our knowledge of factor endowments.

EXPLANATIONS:

Technological choice in developing countries: Reasons for inappropriate choices

(a) Technological rigidity. The production function may not be smooth-shaped.

There may not exist a spectrum of techniques to choose from.

The production function may be L-shaped (Leontief Production Function), implying fixed coefficients of production.

(b) Input prices may fail to reflect relative factor availability.

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Market prices of factors of production may not properly reflect the abundance or scarcity of the relevant factors.

(c) Wage costs per unit of output may differ very little between developed and developing countries.

The Efficiency Wage (Wage Rate/Productivity of Labour) is hardly different.

(d) Labour-intensive techniques may require a great deal of skilled labour, which is in short supply in LDCs.

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(e) Labour-Saving Bias in imported technologies.

LDCs lack the capital goods sector.

Technology innovation carried out in developed countries is of the labour -saving type.

(f) Dependence of foreign aid also often leads to the import of capital-intensive technologies.

Tied foreign aid.

NEED FOR IMPROVED ALLOCATION METHODS

Inherent problems of applying commercial allocation criteria because of

Externalities, decreasing cost industries, etc.; Difficulties of quantifying many benefits; Further complications because of price distortions.

EARLY APPROACHES FOR PROJECT SELECTION:

Use of Partial Investment Criteria

Two such criteria are:

1. The minimum capital-output ratio criterion, advocated by J J Polak (“Balance of Payments Problems of Countries Reconstructing with the Help of Foreign Loans”, QJE 1941, and N S Buchanan, International Investment and Domestic Welfare, 1945. Quoted in A K Sen, Choice of Techniques, 1968, 3rd edition, p. 15).

2. The marginal per capita reinvestment quotient criterion, advocated by W Galenson & H Leibenstein (1955, “Investment Criteria, Productivity and Economic Development, QJE).

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THE MINIMISING CAPITAL-OUTPUT RATIO CRITERION

Suggests for minimising capital intensity per employee, so that the scarce factor, capital, is used in such a way that the rate-of-return (defined as the ratio of output to capital) is maximised.

As investment funds are limited, those projects yielding highest value of annual product relative to investment are selected first.

Y

4 K M 3

2

1

0 L X

Figure 3: Minimising Capital-Intensity per Employee

Labour is represented along the X-axis and capital along the Y-axis. There are four product curves, each representing a particular level of output of a commodity. Given the amount of capital, OK, the maximum amount of output which can be produced, by minimising the capital-intensity per employee, is shown by the equal-product curve 3. The equal cost curve touches the equal product curve 3 at point M. The optimum capital-labour ratio is indicated by the slope of OM. OL represents the amount of labour used.

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It is apparent from Fig. 3 that a horizontal equal-cost curve, as represented by KM is due to the assumption of zero labour cost.

THE MARGINAL PER CAPITA REINVESTMENT QUOTIENT CRITERION

Resources ought to be allocated in such a way so as to maximise output and consumption in the future.

The criterion encourages for minimising the use of labour so that investible surplus per head of labour is maximised.

Consumption and labour use at present will be sacrificed to achieve higher output in the future than would be possible.

The model, which makes a positive contribution by reminding us that important income distributional considerations should not be neglected, has attracted serious criticisms particularly because of its unrealistic assumptions.

It is doubtful whether the MPS out of profits equals one.

It is also wrong to assume that the savings propensity out of wages is zero.

Moreover, an increase in consumption through distribution of income may be a social objective in which case it will be wrong to ignore present consumption.

EMPLOYMENT versus SAVING

The potential conflict between employment and saving emerges from the marginal per capita reinvestment quotient criterion as advised by Galenson & Leibenstein (1955).

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The conflict between employment and saving has also been emphasised by Dobb (1955) and Sen (1968) who illustrated it in its starkest form using a simple production function.

Diagrammatically,

Y WT

M R

01

0 I L L1

K

Z

Fig 4: Optimum Use of Labour with Given Capital

Labour is represented along the horizontal X-axis, output along the vertical Y-axis above the origin and capital along the vertical Z-axis below the origin. Assume that a fixed amount of capital, OK, is used to produce a particular commodity by varying the use of labour (the input of which can be varied under our restrictive assumptions). As more and more labour is used, at the given wage rate (say, a wage rate given in the manufacturing sector in a situation of

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surplus labour), the wage-bill increases linearly as shown by OW. Given the total product curve 00’, output is maximised when OL’ labour is used. The surplus available (assuming that all wages are consumed) over the wage-bill is, however, only TR = TL’ – RL’. On the other hand, surplus is maximised by using OL labour, where a tangent to the total product curve, 00’, is parallel at point M to the wage line OW. Following the Galenson-Leibenstein reinvestment criterion, output at point M will be preferable to output at point T. (Note that the maximum surplus depends on the wage rate and need not necessarily go with the most capital-intensive techniques.)

SOCIAL COST-BENEFIT METHODS (based on ‘shadow prices’ or ‘accounting prices’)

Two pioneering works:

1. I M D Little and J Mirrlees (1968, Manual of Industrial Project Analysis for Developing Countries (Volume II) Social Cost-Benefit Analysis, OECD Development Centre, Paris). Subsequently produced as a successor volume by the authors, Project Appraisal and Planning for Developing Countries, Heinemann 1974; and

2. P Dasgupta, A Sen and S Marglin (1972, Guidelines for Project Evaluation, UNIDO, UN).

The former has come to be known as The OECD Method (and also the LM method, after its authors) and the latter as The UNIDO Method.

THE CONCEPT OF SHADOW PRICING

These prices are not real in the sense that they do not represent current prices of inputs and outputs, but they are true indicators of the realities of economic scarcity of these goods from the social point.

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Such prices, invented for the purpose of social appraisal, are called “shadow prices” or “social accounting prices” or (confusingly) simply “accounting prices”.

As the existing prices fail to reflect adequately the social opportunity costs of the various goods and resources, a system of shadow prices needed to be developed that would give the “right” relative values to the different items.

By using shadow prices, a project planner is avoiding bad guesses and he/she is viewing the costs and benefits of the project not from the point of view of commercial profitability but social profitability.

COMPREHENSIVE SHADOW PRICING IS A SECOND BEST

The OECD and UNIDO authors recognise the second best character of the use of any set of shadow prices.

No claim is made, according to Little and Mirrlees (1974, p. 37) “that accounting prices can be exact reflections of social cost and benefits – merely much better reflections than actual prices for many projects in many countries. Nor, of course, it is claimed that the use of accounting prices is a very satisfactory method of dealing with distortions. Many of the distortions can be fully dealt with only by removing them, that is, by adopting policies which lead to proper correspondence of prices, costs and benefits.”

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VALUATION OF GOODS

(See also Thirlwall (1999), pp. 254-57)Tradables According to the OECD method, all the items – inputs and outputs – which can be traded are valued at ‘Border Prices’.

Non-Tradables(Items which are not normally traded internationally, e.g. electricity and transport)

For minor items, a ‘standard conversion factor’ equal to the rate of the domestic price to international price may be used.

But for major items it is necessary to breakdown the different items of costs.

VALUATION OF FACTORS OF PRODUCTION

Land:

The valuation of land depends on its alternative uses, subject to the use of shadow prices and correction of the adverse effects of income distribution where land is privately owned.

Labour: Distinction between skilled and unskilled labour:

See Thirlwall (1999), pp. 258-60.

Capital:

See Thirlwall (1999), pp. 257-58.

SOCIAL RATE OF RETURN (as distinguished from the COMMERCIAL RATE OF RETURN)

Based on shadow prices.11

DIFFICULTIES OF ADMINISTERING SHADOW OR ACCOUNTING PRICES

Such prices need to be administered at the macro-level.

A country may not have the organisational set-up for this purpose.

Such prices need to be applied systematicallySuch a systematic approach may be lacking in the developing country concerned.

Because of shortage of administration, allocation of resources through a set of alternative prices (different from market prices) will be difficult to carry out efficiently.

EVIDENCE FROM DEVELOPING COUNTRIES

See e.g. M M Huq (1989), The Economy of Ghana, pp 258-66.

Neither of the conditions stated above was satisfied in Ghana (as found by Huq, 1989, p. 261, during the early 1980s when the Ghanaian economy was suffering from serious price distortions).

As there were no central guidelines for the use of a set of shadow prices, different investing agencies were using different criteria in appraising projects in Ghana.

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