Chapter 11

Investment,Productivity,and Growth

Investment and developmentInvestment and development

Relationship between investment and Relationship between investment and developmentdevelopment

The two categories of investment, public The two categories of investment, public and private. and private.

Investment and developmentInvestment and development

Private investment plays a dominant role Private investment plays a dominant role in developing countries.in developing countries.

The importance of the effective use of The importance of the effective use of capital.capital.– Allows the firms and governments to escape Allows the firms and governments to escape

diminishing returns to capital.diminishing returns to capital.

Investment and developmentInvestment and development

The efficient use of investment is often The efficient use of investment is often more important for growth than the sheer more important for growth than the sheer volume of investment.volume of investment.– Depends, Depends, inter aliainter alia, on whether prices , on whether prices

(including wages, exchange rates, interest (including wages, exchange rates, interest rates) are aligned with the social cost of rates) are aligned with the social cost of resources. Distortions (tariffs/subsidies, resources. Distortions (tariffs/subsidies, externalities, market power) impede proper externalities, market power) impede proper allocation.allocation.

Investment and developmentInvestment and development

Text example:Text example:– Country A subsidizes new activities (in Country A subsidizes new activities (in

industries where the country lacks industries where the country lacks comparative advantage), but materials and comparative advantage), but materials and managers are expensive and scarce.managers are expensive and scarce.

– Country B emphasizes industries in which the Country B emphasizes industries in which the country has a comparative advantage, builds country has a comparative advantage, builds infrastructure, removes regulations and tariffs.infrastructure, removes regulations and tariffs.

The Investment DecisionThe Investment Decision

In analyzing which projects to undertake, In analyzing which projects to undertake, both the public and private sectors rely on both the public and private sectors rely on traditional cost-benefit analysis.traditional cost-benefit analysis.

Compare:Compare:– Costs, expected payoffs, risks.Costs, expected payoffs, risks.– NotNot economy-wide net present value. economy-wide net present value.

What is the time-profile of cash flow?What is the time-profile of cash flow?

Year 0 1 2 3 4 5 6 Sum

Project A

-500 0 0 0 325 325 325 475

Project B

-500 900 0 0 0 0 0 400

NPV of A

-500 0 0 0 267 255 243 265

NPV of B

-500 857 0 0 0 0 0 357

nr

CostsBenefitsPV

)1(

r=5%

The Investment DecisionThe Investment Decision

In calculating Net Present Value (NPV), In calculating Net Present Value (NPV), public and private projects take into public and private projects take into account different aspects of opportunity account different aspects of opportunity costs.costs.– What are the alternative investments for a What are the alternative investments for a

government? For a private firm? government? For a private firm? – What return could have been earned?What return could have been earned?– What are the alternative uses of resources?What are the alternative uses of resources?

The Investment DecisionThe Investment Decision

Public projects must considerPublic projects must consider– shadow prices (when market prices do not shadow prices (when market prices do not

reflect the true cost of resources)reflect the true cost of resources)– and welfare weights (valuation of non-and welfare weights (valuation of non-

economic benefits).economic benefits).

Projects are typically public if there are Projects are typically public if there are high entry costs and large externalities, high entry costs and large externalities, such as in infrastructure.such as in infrastructure.

The Investment DecisionThe Investment Decision

The private sector focuses on the The private sector focuses on the comparison between the marginal revenue comparison between the marginal revenue productproduct– (marginal product x marginal revenue)(marginal product x marginal revenue)

The Investment DecisionThe Investment Decision

The private sector also often considers The private sector also often considers factors that can be influenced by factors that can be influenced by government policy such as government policy such as – macroeconomic and political stability, macroeconomic and political stability, – infrastructure, infrastructure, – trade policy, trade policy, – institutions,institutions,– the cost of doing business. the cost of doing business.

http://siteresources.worldbank.org/INTWDR2005/Resources/02_WDR_Overview.pdf

The Investment DecisionThe Investment Decision

The cost of doing business includes The cost of doing business includes administrative costs and bureaucratic administrative costs and bureaucratic procedures.procedures.– Some of these procedures are directed at Some of these procedures are directed at

obtaining unnecessary information and obtaining unnecessary information and slowing business down, but others reflect slowing business down, but others reflect relatively underdeveloped information relatively underdeveloped information systems.systems.

These procedures typically do not result in These procedures typically do not result in the same protection for private property.the same protection for private property.

FDIFDI

Foreign direct investment (FDI), which Foreign direct investment (FDI), which accounts for about half of all private flows, accounts for about half of all private flows, has generated considerable controversy has generated considerable controversy because it involves foreign ownership and because it involves foreign ownership and management of productive enterprises. management of productive enterprises.

FDI is hoped to provide jobs, technical FDI is hoped to provide jobs, technical progress, management skills, and access progress, management skills, and access to world markets.to world markets.

FDIFDI

The impact of FDI, which comes from The impact of FDI, which comes from multinational corporations (MNCs), multinational corporations (MNCs), depends greatly on policies adopted by depends greatly on policies adopted by the host countries, including performance the host countries, including performance requirements, trade protection, and requirements, trade protection, and incentives such as tax holidays. incentives such as tax holidays.