Unlimited supply of labour (Arthur Lewis)

Structural-change theory focuses on the mechanism by which underdeveloped

economies transform their domestic economic structures from a heavy emphasis on
traditional subsistence agriculture to a more modern, more urbanized, and more
industrially diverse manufacturing and service economy. It employs the tools of
neoclassical price and resource allocation theory and modern econometrics to describe how
this transformation process takes [Link] well-known representative examples of the
structural-change approach are the “two-sector surplus labor” theoretical model of W.
Arthur Lewis and the “patterns of development” empirical analysis of Hollis B. Chenery

The Lewis Theory of Development

Basic Model One of the best-known early theoretical models of development that focused
on the structural transformation of a primarily subsistence economy was that formulated
by Nobel laureate W. Arthur Lewis in the mid -1950s and later modified, formalized, and
extended by John Fei and Gustav
Ranis.5 The Lewis two-sector model became the general theory of the development
process in surplus-labor developing nations during most of the 1960s and early 1970s, and
it is sometimes still applied, particularly to study the recent growth experience in China
and labor markets in other developing countries.6
In the Lewis model, the underdeveloped economy consists of two sectors: a traditional,
overpopulated rural subsistence sector characterized by zero marginal labor productivity—
a situation that permits Lewis to classify this as surplus labor in the sense that it can be
withdrawn from the traditional agricultural sector without any loss of output—and a high-
productivity modern urban industrial sector into which labor from the subsistence sector is
gradually transferred. The primary focus of the model is on both the process of labor
transfer and the growth of output and employment in the modern sector. (The modern
sector could include modern agriculture, but we will call the sector “industrial” as a
shorthand). Both labor transfer and modern-sector employment growth are brought about
by output expansion in that sector. The speed
with which this expansion occurs is determined by the rate of industrial investment and
capital accumulation in the modern sector. Such investment is made possible by the excess
of modern-sector profits over wages on the assumption that capitalists reinvest all their
profits. Finally, Lewis assumed that
the level of wages in the urban industrial sector was constant, determined as a
given premium over a fixed average subsistence level of wages in the traditional
agricultural sector. At the constant urban wage, the supply curve of rural labor to the
modern sector is considered to be perfectly elastic.
We can illustrate the Lewis model of modern-sector growth in a two-sector
economy by using Figure 3.1. Consider first the traditional agricultural sector
portrayed in the two right-side diagrams of Figure 3.1b. The upper diagram
shows how subsistence food production varies with increases in labor inputs.
It is a typical agricultural production function in which the total output or
product (TPA) of food is determined by changes in the amount of the only variable input,
labor (LA), given a fixed quantity of capital, KA, and unchanging
 KM3> KM2 > KM1
TPM (KM 3)

TPM (KM 2)
TPA
KA)

TPM (KM1)
Total product (food)

TPA
= WA
(manufactures)
Total product

L1 LM LA

KM3> KM2> KM1

Average (marginal) products

APLA
Real wage (= MPLM)

D1 MPLA

F G
WM
WA D3 (KM 3)
WA
D2 (KM2) MPLA
D1 (KM 1) = MP LM APLA
L3
L1

Quantity of labor (QLM) (thousands) Quantity of labor (QLA) (millions)

(a) Modern (industrial) sector
traditional technology, . In the lower-right diagram, we have the average and marginal product
of labor curves, APLA and MPLA, which are derived from the total product curve shown
immediately above. The quantity of agricultural labour (QLA) available is the same on both
horizontal axes and is expressed in millions of workers, as Lewis is describing an underdeveloped
economy where much of the population lives and works in rural areas. Lewis makes two
assumptions about the traditional sector. First, there is surplus labour in the sense that MPLA is
zero, and second, all rural workers share equally in the output so that the rural real wage is
determined by the average and not the marginal product of labour (as will be the case in the
modern sector). Metaphorically, this may be thought of as passing around the family rice bowl at
dinnertime, from which each person takes an equal share (this need not be literally equal shares
for the basic idea to hold). Assume that there are LA agricultural workers producing TPA food,
which is shared equally as WA food per person (this is the average product, which is equal to
TPA/LA).
The marginal product of these LA workers is zero, as shown in the bottom diagram of Figure
3.1b; hence the surplus-labor assumption applies to all workers in excess of LA (note the
horizontal TPA curve beyond LA workers in the upper-right diagram). The upper-left diagram of
Figure 3.1a portrays the total product (production function) curves for the modern industrial
sector. Once again, output of, say, manufactured goods (TPM) is a function of a variable labour
input, LM, for a given capital stock and technology, . On the horizontal axes, the quantity of
labour employed to produce an output of, say, TPM1, with capital stock KM1, is expressed in
thousands of urban workers, L1. In the Lewis model, the modern-sector capital stock is allowed
to increase from KM1 to KM2 to KM3 as a result of the reinvestment of profits by industrial
capitalists. This will cause
the total product curves in Figure 3.1a to shift upward from TPM(KM1) to TPM(KM2) to
TPM(KM3). The process that will generate these capitalist profits for reinvestment and growth is
illustrated in the lower-left diagram of Figure 3.1a. Here we have modern-sector marginal labor
product curves derived from the TPM curves of the upper diagram. Under the assumption of
perfectly competitive labour markets in the modern sector, these marginal product of labor curves
are in fact the actual demand curves for labour. Here is how the system works. WA in the lower
diagrams of Figures 3.1a and 3.1b represents the average
level of real subsistence income in the traditional rural sector. WM in Figure 3.1a is therefore the
real wage in the modern capitalist sector. At this wage, the supply of rural labour is assumed to
be unlimited or perfectly elastic, as shown by the horizontal labour supply curve WMSL. In other
words, Lewis assumes that at urban wage WM above rural average income WA, modern-sector
employers can hire as many surplus rural workers as they want without fear of rising wages.
(Note again that the quantity of labour in the rural sector, Figure 3.1b, is expressed in millions
whereas in the modern urban sector, Figure 3.1a, units of labour are expressed in thousands.)
Given a fixed supply of capital KM1 in the initial stage of modern-sector growth, the demand
curve for labour is determined by labour’s declining marginal product and is shown by the
negatively sloped curve D1(KM1) in the lower-left diagram. Because profit-maximizing modern-
sector employers are assumed to hire laborers to the point where their marginal physical product
is equal to the real wage (i.e., the point F of intersection between the labor demand and supply
curves), total modern sector employment will be equal to L1. Total modern-sector output, TPM1,
would be given by the area bounded by points 0D1FL1. The share of this total
output paid to workers in the form of wages would be equal, therefore, to the
area of the rectangle 0WMFL1. The balance of the output shown by the area
WMD1F would be the total profits that accrue to the capitalists. Because Lewis
assumes that all of these profits are reinvested, the total capital stock in the
modern sector will rise from KM1 to KM2. This larger capital stock causes the
total product curve of the modern sector to shift to TPM(KM2), which in turn
induces a rise in the marginal product demand curve for labor. This outward
shift in the labor demand curve is shown by line D2(KM2) in the bottom half of
Figure 3.1a. A new equilibrium modern-sector employment level will be established at point G
with L2 workers now employed. Total output rises to TPM2 or 0D2GL2 while total wages and
profits increase to 0WMGL2 and WMD2G, respectively. Once again, these larger (WMD2G)
profits are reinvested, increasing the total capital stock to KM3, shifting the total product and
labor demand curves to TPM(KM3) and to D3(KM3), respectively, and raising the level of
modern-sector employment to L3.
This process of modern-sector self-sustaining growth and employment
expansion is assumed to continue until all surplus rural labor is absorbed in
the new industrial sector. Thereafter, additional workers can be withdrawn
from the agricultural sector only at a higher cost of lost food production because the declining
labor-to-land ratio means that the marginal product of rural labor is no longer zero. This is known
as the “Lewis turning point.” Thus the labor supply curve becomes positively sloped as modern-
sector wages and employment continue to grow. The structural transformation of the economy
will have taken place, with the balance of economic activity shifting from traditional rural
agriculture to modern urban indust ry.

Vicious circle of poverty (Ragnar nurkse)

The basic characteristics of underdeveloped countries discussed in the preceding chapter might as well
be regarded as the obstacles to their economic development. Even though the general characteristics of
underdevelopment is not common to all the underdeveloped countries, yet a broad answer to the
question ‘why a poor country is poor’ is implicit in these characteristics. A number of these
characteristics are both the cause and consequence of poverty. The following factors analyse the mutual
causative relationship that inhibit development.
There are circular relationships known as the ‘vicious circles of poverty’ that tend to perpetuate the low
level of development in LDCs. Nurkse explains the idea in these words: “It implies a circular
constellation of forces tending to act and react upon one another in such a way as to keep a poor
country in a state of poverty. For example, a poor man may not have enough to eat; being underfed, his
health may be weak; being physically weak, his working capacity is low, which means that he is poor,
which in turn means that he will not have enough to eat; and so on. A situation of this sort relating to a
country as a whole, can be summed up in the trite proposition: “A country is poor because it is poor.”1
The basic vicious circle stems from the fact that in LDCs total productivity is low due to deficiency of
capital, market imperfections, economic backwardness and underdevelopment. However, the vicious
circles operate both on the demand side and the supply side. The demand-side of the vicious circle is that
the low level of real income leads to a low level of demand which, in turn, leads to a low rate of
investment and hence back to deficiency of capital, low productivity and low income. This is shown in
Fig. 1. Low productivity is reflected in low real income. The low level of real income means low saving.
The low level of saving leads to low investment and to deficiency of capital. The deficiency of capital, in
turn, leads to low level of productivity and back to low income. Thus the vicious circle is complete from
the supply side. It is depicted in Fig. 2. The low level of real income, reflecting low investment and
capital deficiency is a common feature of both the vicious circles.
A third vicious circle envelops underdeveloped human and natural resources. Development of natural
resources is dependent upon the productive capacity of the people in the country. If the people are
backward and illiterate, lack in technical skill, knowledge and entrepreneurial activity, the natural
resources will tend to remain unutilised, underutilized or even misutilized. On the other hand, people are
economically backward in a country due to underdeveloped natural resources. Underdeveloped natural
resources are, therefore, both a consequence and cause of the backward people.2 This is explained in Fig.3

“Poverty and

underdevelopment of the economy are thus synonymous. A country is poor because it is

underdeveloped. A country is underdeveloped because it is poor and remains underdeveloped as it has
not the necessary resources for promoting development. Poverty is a curse, but a greater curse is that it is
self-perpetuating.”3

LOW RATE OF CAPITAL FORMATION

The most pertinent obstacle to economic development is the shortage of capital. This stems from the
vicious circles of poverty analysed above. Poverty is both a cause and a consequence of a country’s low
rate of capital formation. In an underdeveloped country, the masses are poverty-ridden, they are mostly
illiterate and unskilled, use outmoded capital equipment and methods of production. They practise
subsistence farming, lack mobility and have little connection with the market sector of the economy.
Their marginal productivity is extremely low. Low productivity leads to low real income, low saving, low
investment and to a low rate of capital formation. The consumption level is already so low that it is
difficult to restrict it further to increase the capital stock. That is why millions of farmers in such
countries use outmoded and obsolete capital equipment. Such small sums as they may be able to save
are often hoarded in the form of currency or used in purchasing gold and jewellery, etc. The inclination
to hoard money is due to absence of banking facilities in rural areas. No wonder, there is little capital
formation in underdeveloped countries.
It is the high income group that does most of the savings in underdeveloped countries. But these savings
do not flow into productive channels. On the other hand, they are dissipated “into real estate, gold,
jewellery, commodity hoards and hoards of foreign or domestic currency, money lending and
speculation.”4 Thus ‘value-retaining’ objects and durable consumer goods dominate their expenditure
pattern. In addition, conspicuous consumption plays an important part in their consumption patterns.
Consequently, they prefer an imported article for its prestige value to an equally good domestic article.
But what are the main reasons for the lack of incentives to save and invest in underdeveloped countries?
These include, imperfect maintenance of law and order, political instability, unsettled monetary
conditions, lack of continuity in economic life, the extended family system with its drain on resources,
and its stifling of personal initiative and certain systems of land tenure.” The other reasons which inhibit
investment are:
Firstly, sheer habit. It is always easier to attempt the familiar than the unfamiliar. By nature man is
happy in his old moorings and would not like to take risks in new ventures.
Secondly, small extent of the domestic market. The capacity of the domestic market to absorb new
supplies of commodities is limited due to the low purchasing power of the masses.
Thirdly, the difficulties of securing funds for investment purposes are also insurmountable. Many
manufacturing activities require large capital-outlays which are difficult to obtain due to lack of a well-
developed capital and stock market, and credit and banking system.
Fourthly, the lack of skilled labour and factor mobility enhance the cost of production and thereby
hamper potential investors.
Fifthly, absence or inadequacy of basic services like transportation, power and water-supply, etc.,
further reduce the inducement to invest.
Lastly, the entrepreneurial ability in itself is a scarce factor in most of the underdeveloped countries.
Whatever little entrepreneurship is available, that is scared away by high risks involved in investment.
The traders and merchants are mostly engaged in the export industry which consists of primary products.
Thus, there is no addition to the real stock of capital in these countries.
In between the low income and high income groups, there is a small middle income group. It is mostly
engaged in well-established and less risky ventures, such as providing marketing and other services. This
group, though not lacking in entrepreneurial ability, is reluctant to invest in manufacturing industries for
the reasons which are not far to seek. There is the difficulty of obtaining institutional and corporate
finance, advanced technology, trained labour and management. Above all, the difficulties enumerated in
the preceding para go together to inhibit the growth of capital in such countries.

SOCIO-CULTURAL CONSTRAINTS

No doubt shortage of capital is a serious obstacle but it is not the only obstacle to economic development.
As Nurkse has said: “Economic development has much to do with human endowments, social attitudes,
political conditions and historical accidents. Capital is a necessary but not a sufficient condition of
progress.”5 Broadly speaking, underdeveloped countries possess social institutions and display such
attitudes as are not conducive to economic development. According to the UN Report on Processes and
Problems of Industrialization in Underdeveloped Countries there are ‘elements of social resistance to
economic change’ in underdeveloped countries which include institutional factors characterized by ‘rigid
stratification of occupations’ reinforced by traditional beliefs and values; attitudes involving ‘inferior
valuation attached to business roles and their incompatibility with the patterns of living and concepts of
social dignity upheld by the high status groups’ and ‘factionalism’ which has been defined as ‘the
tendency of the society; to be divided by caste and class cleavages, ethnic or religious distinctions,
differences in cultural tradition and social pattern, kinship loyalties and regional identification. Such
factors tend to inhibit social and geographical mobility and constitute a drag on progress. The people of
such countries are averse to accept new values created by the impact of innovations.
The family is the primary economic and social unit. Family attitudes are responsible for population
pressures and attachment to land. They also limit the range of individual freedom in making economic
decisions which in turn influence the motives to save and invest. Money is hoarded or invested in gold,
jewellery or in real estate or is spent to meet social obligations on ceremonial occasions to maintain
status. Ostentatious expenditure, better known as conspicuous consumption, on the part of the wealthier
classes also limits the capacity to save and invest.
In such a society relations are personal or patriarchal rather than universal. People are influenced by
kinship or status as determined by caste, clan or creed. “It appears to be difficult to disentangle a person’s
abilities and capacities as a worker from his caste, religious beliefs, social or geographical origin or
other attributes that have little to do with his potential contribution to production. Consequently, efficiency
suffers because special abilities go unused.”6 Moreover, administrators, managers, politicians and policy
makers belong to the privileged and dominant classes of society. Since such persons do not have the best
talents, they stand in the way of good government, clean administration, and in the efficient working of
large-scale enterprises. They lead to nepotism, bribery, favouritism and inefficient administration. Bad
administration whether in private or public enterprise makes economic development all the more difficult.
Social attitude towards education is further inimical to economic progress. Purely academic education
which trains people for government and other clerical jobs is preferred to technical and professional
education in such countries. There is prejudice against manual work which is despised and ill-rewarded.
Consequently, there develops a natural distaste for practical work and training that leads to technological
backwardness.
Oriental religions give less inducements to the virtues of thrift and hard work. People in such societies
regard work as a necessary evil rather than a virtue. They place high values on leisure, contentment and
participation in festivals and religious ceremonies. Thus, money that can be usefully invested is
dissipated in uneconomic ventures. People do not believe that progress is possible through human efforts
and man is not helpless before the blind forces of fate. Religious dogmas inhibit progress, for they
prevent social, economic and political institutions to change in a way that is conducive to economic
development. As Dr. S. Radhakrishnan observed, “The qualities associated with the Eastern culture make
for life and stability; those characteristics of the West for progress and adventure.”7

AGRICULTURAL CONSTRAINT

Another obstacle relates to the agricultural sector. The majority of LDCs are predominantly agricultural.
Agricultural production constitutes a large share of their GDP and agricultural commodities form a
considerable part of the value of their total exports. “Agricultural practices are controlled by custom and
tradition. A villager is fearful of science. For many villagers insecticide is taboo. . . . A new and
improved seed is suspect. To try it is a gamble. Fertilisers, for example, are indeed a risk. . . . To adopt
these untried methods might be to risk failure. And failure could mean starvation.”8 It is, in fact, not the
behaviour of farmers that acts as a constraint on agricultural growth. Instead, the constraints are to be
found in the environment in which farmers operate the technology available to them, the incentives for
production and investment, the availability and price of inputs, the provision of irrigation, and the climate.
The LDCs situated in tropical and sub-tropical zones are at a disadvantage in terms of climate. Due to
heat and torrential rains, their soils are poor as they contain little organic matter. As a result of the
environmental factors, agricultural output fails to increase to meet the rising demand of the developing
economy. Further, when the growth rate of population is also high, per capita agricultural and food output
may actually decline instead of increasing, as was the case with the low income countries during 1970-80
when their per capita agricultural output declined by 0.4 per cent and per capita food output by 0.3 per
cent per year. That is why the percentage share of food in the merchandise imports of many LDCs has
been more than 25 per cent which entails a heavy burden on their foreign exchange resources. Thus the
poor performance of the agricultural sector is a major constraint on the sluggish economic growth of
LDCs.

HUMAN RESOURCES CONSTRAINT

Undeveloped human resources are an important obstacle to economic development in LDCs. Such
countries lack in people possessing critical skills and knowledge required for all-round development of
the economy. The existence of surplus labour in them is to a considerable extent due to shortage of critical
skills. Undeveloped human resources are manifest in low labour productivity, factor immobility, limited
specialisation in occupation, and in customary values and traditional social institutions that minimise the
incentives for economic development. Further, “the economic quality of the population remains low when
there is little knowledge of available natural resources, possible alternative production techniques,
necessary skills, existing market conditions and opportunities, and institutions that might be created to
favour economising effort and economic rationality.” Since LDCs have a dearth of critical skills and
knowledge, physical capital, whether indigenous or imported, cannot be productively utilised. As a result,
machines breakdown and wearout soon, materials and components are wasted, the quality of production
falls, and costs rise.

FOREIGN EXCHANGE CONSTRAINT

Economists like Myint, Prebisch, Singer, Lewis and Myrdal maintain that certain ‘disequalising forces’
have been operating in the world economy as a result of which the gains from trade have gone mainly to
the developed countries leading to foreign exchange constraint.
After the opening up of underdeveloped countries to world markets, there has been a phenomenal rise in
their exports. But this has not contributed much to the development of the rest of the economy of these
countries, as the export sector has developed to the utter neglect of other sectors of the economy. On the
other hand, too much dependence on exports has exposed these economies to international fluctuations in
the demand for and prices of their products. They have become unstable due to cyclical-instability and
balance of payments difficulties. During a depression, the terms of trade become adverse and foreign
exchange earnings fall steeply. As a result, they suffer from unfavourable balance of payments. But they
are unable to take advantage of a fall in the prices of their products by increasing their exports due to the
inelastic nature of supply of their export goods which are mainly agricultural and mineral products.
Similarly, they are unable to benefit from a boom in world market. An improvement in their terms of trade
is not accompanied by an increase in output and employment due to market imperfections, inadequate
overhead capital and structural maladjustments. On the contrary, increased export earnings lead to
inflationary pressure, malallocation of investment expenditure and to balance of payments difficulties.
As a result, there has been a secular deterioration in the income terms of trade (or the capacity to import)
of LDCs so that they are faced with foreign exchange constraint. This has led to the need for larger inflow
of aid and foreign investment. Consequently, debt servicing of amortisation and interest of debt have
risen, income payments of dividends and profits on private direct foreign investment have grown, and the
net inflow of foreign capital has declined. All these have led to further shortage of foreign exchange
reserves which acts as a severe limitation on the development programme of LDC.

Karl Marxian theory

INTRODUCTION

Karl Marx, the celebrated author of ‘Das Kapital’, is one of the few celebrities in history who cast a spell
on hundreds of millions of people by his doctrines. He has been epitomized as ‘Marx the Prophet’ and is
ranked with Christ and Mohammad if we are to judge him by the number of his followers. As Schumpeter
wrote, “Marxism is a religion. To the orthodox Marxist, as any believer in a Faith, the opponent is not
merely in error but in sin.”1 Marx predicted the inevitable doom of capitalism and it was on this
prediction that communism has built its edifice. The Marxian analysis is the gravest and the most
penetrating examination of the process of capitalist development. It had the greatest influence in shaping
policies in the Soviet Union, China, and other communist countries. Our purpose here is to examine the
Marxian process of economic development and not the Marxist system as whole.

THE MARXIAN THEORY

“Marx contributed to the theory of economic development in three respects, namely, in broad respect of
providing an economic interpretation of history, in the narrower respect of specifying the motivating
forces of capitalist development, and in the final respect of suggesting an alternative path of planned
economic development.”

Materialistic interpretation of History.

The materialistic interpretation of history attempts to show that
all historical events are the result of a continuous economic struggle between different classes and groups
in society. The main cause of this struggle is the conflict between ‘the mode of production’ and ‘the
relations of production.’ The mode of production refers to a particular arrangement of production in a
society that determines the entire social, political and religious way of living. The relations of
production relate to the class structure of a society “uniquely characterised” by the following
components: (i) the organisation of labour in a scheme of division and co-operation, the skills of labour
and the status of labour in the social context with respect to degrees of freedom or servitude; (ii) the
geographical environment and the knowledge of the use of resources and materials; and (iii) technical
means and processes and state of science generally.2 Keeping these in view, Marx explains his process of
economic development.

THE MARXIAN PROCESS OF ECONOMIC DEVELOPMENT

According to Marx, every society’s class structure consists of the propertied and the non-propertied
classes. Since the mode of production is subject to change, a stage comes in the evolution of a society
when the forces of production come into clash with the society’s class structure. The existing property
relations “turn into fetters” on the forces of production. Then comes the period of ‘social revolution.’ This
leads to the class struggle—the struggle between the have and the have-nots—which ultimately
overthrows the whole social system.
Surplus Value. Marx uses his theory of surplus value as the economic basis of the ‘class struggle’ under
capitalism and it is, on the basis of his theory of surplus value that he builds the super structure of his
analysis of economic development. Class struggle is simply the outcome of accumulation of surplus value
in the hands of a few capitalists. Capitalism, according to Marx, is divided into two great protagonists:
the workers who sell their ‘labour-power’ and the capitalists who own ‘the means of production.’ Labour
power is like any other commodity.
The capitalist gives raw materials, machines etc. to labourers. When manufactured goods are sold, the
capitalist finds that the amount of money he receives is more than the amount spent on the production of
commodities. This can be expressed in this way. A capitalist comes to the market with some amount of
money M and buys factors of production like raw materials, machines, labour power, etc. With these, he
manufactures commodity C which he sells at more money M’. In this way, the equation becomes :
M→C→M’, where M’ > M. Thus the difference between M’ and M is the surplus value. According to
Marx, the cause of this surplus value is not raw materials, machines, etc. because their contribution to
production is not more than their contribution to production is not more than their value. Therefore, the
surplus value arises only from labour power.
The labourer sells his labour for what it is worth in the labour market, viz., for its value. And its value,
like the value of any other commodity, is the amount of labour that it takes to produce labour-power. In
other words, the value of labour-power is the value of the means of subsistence necessary for the
maintenance of the labourer, which is determined by, the number of hours necessary for its production.
According to Marx, the value of the commodities necessary for the subsistence of the labour is never
equal to the value of the produce of that labour. If a labourer works for a ten-hour day, but it takes him six
hours’ labour to produce goods to cover his subsistence, he will be paid wages equal to six hours’ labour.
The difference worth 4 hours’ labour goes into the capitalist’s pocket in the form of net profits, rent and
interest. Marx calls this unpaid work “surplus value.” The extra labour that a labourer puts in and for
which he receives nothing, Marx calls “surplus labour.”
Capital Accumulation. According to Marx, it is surplus labour that leads to capital accumulation. This
supererogatory labour simply augments the capitalist’s profits. The capitalist’s main motive is to increase
the surplus value which goes to swell his profits. He tries to maximize his profits in three ways: (1) by
prolonging the working day in order to increase the working hours of surplus labour. If the working hours
are extended from ten to twelve the surplus will automatically increase from four to six; (2) by
diminishing the number of hours required to produce the labourer’s sustenance. If they were reduced from
six to four, the surplus would again rise from four to six. It also tantamount to a reduction in the
subsistence wage; (3) by ‘the speeding up of labour’, i.e., increasing the productivity of labour. This
requires it technological change that helps in raising the total output and lowering the cost of production.
According to Marx, women and children are also employed on machines that leads to increase in the
surplus value.
Of the three methods, according to Marx, increase in the productivity of labour is the likely choice of the
capitalists, since the other two methods of extending the working hours and reduction of wages have
limitations of their own. So in order to make improvements in the productivity of labour, the capitalists
save the surplus value, reinvest it in acquiring a large stock of capital and thus accumulate capital.
“Accumulate, accumulate! That is Moses and the Prophets,” and “Save, i.e., reconvert the greatest
possible portion of surplus value or surplus product into capital.” These are the capitalist’s methods.
Profits are determined by the amount of capital. As Marx says, “Capital is dead labour that vampire like
only lives by sucking living labour and lives the more, the more labour it sucks.” To explain the origin of
profit and to analyse the relation between wages and profits, Marx separates capital into constant capital
and variable capital. Capital invested in stocks or raw materials or equipment which directly assists the
productivity of labour, Marx calls constant capital (c). Capital devoted to the purchase of labour power
in the form of wages or direct subsistence, he terms variable capital (v). The surplus value is denoted by
(s). So the total value of product (w) = constant capital (c) + variable capital (v) + surplus value (s ) or (c
+ v) + s.
It is on the basis of this division of the total output that Marx introduces his Departmental Schema of
Simple and Expanded Reproduction.
Marx divides the total output of the economy (w) into Department 1 and Department 2. The former is
related to the production of capital goods and the latter to consumer goods. The total output of each
Department is shown as

The Simple Reproduction Scheme indicates a situation of stationary state in which all that is produced is
consumed. Thus net investment is zero and there is no accumulation or surplus. Therefore, equality
prevails in both the Departments. Hence the value of total constant capital in both the Departments (c1 +
c2) must equal the output of Department 1 ( c1+ v1 + s1), that is

Similarly, the total consumption in both the Departments (v1 + s1 + v2 + s2) must equal the total output
of Department 2 (c2 + v2 + s2), that is

By eliminating the common factor (v2 + s2 )

This shows that the value of constant capital in Department 2 must equal the value of commodities
consumed by workers (v1) and capitalists (s1) in Department 1.
It is in Marx’s Expanded Reproduction Scheme that accumulation takes place because the production of
Department 1 (capitalist sector) is greater than the demand for constant capital in both the Departments,
that is

This shows that accumulation is taking place which is being invested in employing more labour (v1) and
the means of production (c1) in Department 1 than in Department 2. These, in turn, increase the surplus
value (s1).
In order to analyse the nature of capitalist accumulation, Marx establishes certain relationships between c,
v, and s. The ratio of constant to variable capital (c/v) , is termed as the organic composition of capital.
The rate of surplus value is defined as s/v, the ratio of surplus value to variable capital or of profits to
wages. This is known as the degree or rate of exploitation. This leads Marx to point out that the rate of
profit is not dependent solely on the rate of surplus value. The rate of profit (r) can change even though the
rate of surplus value (s/v) remains constant, if a change occurs in the organic composition of capital (c/v).
The influence of technical progress is to alter the organic composition of capital, generally in the
direction of raising the ratio of constant to variable capital. Hence the tendency of industrial progress is to
lower the rate of profit r, even though there is no decrease in the rate of surplus value.
One of the consequences of capital accumulation is the concentration of
capital in gigantic enterprises. Competition among capitalists forces them
to cheapen their products. This can be done by introducing labour-saving
machines which increase labour productivity. Those capitalists who are

unable to replace labour by machines are ‘squeezed out’ and their

enterprises are taken over by big capitalists.

Capital accumulation and concentration involve increase in constant capital

and decline in variable capital. The rapid growth of constant capital as
compared with variable capital leads to a relative decrease in the demand
for labour. This process of supplanting labour by machines creates an industrial reserve army which
increases as capitalism develops. The larger the industrial reserve army,
the worse are the conditions of the employed workers, since the capitalist can dismiss dissatisfied and
troublesome workers, being able to replace them from the ranks of the reserve army. Capitalists are also
able to cut down wages to a semi-starvation level and appropriate more and more surplus value. This is
the law of the increasing misery of the masses under capitalism. This is shown in Fig. 1 where the
labour
force is taken on the horizontal axis and the wage rate on the vertical axis. D is the demand curve for
labour and S is the supply curve of labour. At the wage rate W , there is an increase in the industrial
reserve army equal to RA (=LL1) because the supply of labour is more than the demand for labour. As the
industrial reserve army expands, capitalists start adopting labour-saving machines and reduce the wage
rate to the minimum subsistence level OM in order to have more surplus value.

DOWNFALL OF CAPITALISM
But when the capitalist is replacing the workers by machines, he is killing the goose that laid the golden
eggs. There is a continual reduction of the surplus value. Marx believes that technological progress tends
to increase the organic composition of capital (c/v). Since the rate of profit is inversely related to the
organic composition of capital, the former tends to decline with accumulation. Marx explained this
tendency of falling rate of profit in terms of the following equation:
The rate profit (r) varies inversely with the organic composition of capital (c/v) and directly with the rate
of surplus value (rate of exploitation (s/v). Therefore, the rate of profit r rises with the rate of surplus
value s/v and falls with the organic composition of capital c/v.
Marx’s law of falling rate of profit is explained in Fig. 2. Marx
moves on the presumption that as the capitalists use more
machines (constant capital), they keep the supply of labour
constant. In the Figure the amount of capital is taken on the
horizontal axis and total output on the vertical axis. The total
output curve OP that slopes upto point A, total output increases at
an increasing rate and after that at a diminishing rate. It means that

as more machines are installed while keeping the supply of labour

constant, the law of diminishing returns operates. Total wage bill
is constant at OT and the horizontal line TW shows constant supply
of labour as the amount of capital increases. A tangent TT1 touches
the total output curve OP at point A and a perpendicular AK1 from
A cuts the TW line at S1. Similarly another line TT2 from T cuts the OP curve from below at B and a
perpendicular BK2 from it cuts the line TW at S2 .
With OK1 capital on machines, total output is AK1 , total profit to capitalists is AS1 and total wages are
S1K1. The rate of profit is α = AS1/TS1. If to increase the rate of profit, capitalists use more capital than
OK1, the rate of profit declines. When OK2 capital is used, the rate of profit is α’ = BS2/TS2 which is
less than AS1/TS1. Thus when more capital is used on machines, the rate of profit actually declines.

Capitalist Crisis. In order to counteract this tendency of declining rate of profit, the capitalists increase
the degree of exploitation by reducing wages, lengthening the working day and by “speed ups,” etc. But
since every capitalist is engaged in introducing new labour-saving and cost-reducing devices, the ratio of
labour (and hence surplus value) to total output falls still further. The rate of profit declines all the more.
Production is no longer profitable. Consumption dwindles as machines displace men and the industrial
reserve army expands. Bankruptcies ensue. Every capitalist tries to dump goods in the market and in the
process small firms disappear. A capitalist crisis has begun. The ultimate cause of all economic crisis,
Marx points out is the poverty and limited purchasing power of the masses. Economic crisis appears in
the form of an over production of commodities, acute difficulties in finding markets, a fall in prices and a
sharp curtailment of production. During the crisis, unemployment increases sharply, the wages of workers
are further cut, credit facilities breakdown and small employers are ruined.
This does not continue for ever. Revival soon starts. The low level of prices, cut in wages, elimination of
speculative ventures and destruction of capital tend to raise the profit rate which eventually leads to new
investments. As Marx wrote, “A crisis always forms the starting point of large new investments.
Therefore, from the point of view of society as a whole a crisis is, more or less, a new material basis for
the next turnover cycle. But it leads to the same catastrophic conclusion: competition for labour; higher
wages labour-saving machinery; a reduction in surplus value; decline in profit rate; still greater
competition and collapse. This succession from crisis to depression, followed by recovery and boom and
then again crisis is evidence of the cycle character of the development of capitalist production.
In each period of crisis stronger capitalists expropriate the weaker capitalists and along with it grows the
indignation of the working class, which is always increasing in numbers and is disciplined, united and
organised by the very mechanism of the process of capitalist production itself. This leads to the struggle
between the working class and the capitalists. This is the historical tendency of capitalist development. In
elaborating the general law of capitalist development, Marx provides the economic explanation of the
necessity and inevitability of the revolutionary transformation from capitalist to socialist society.
Capitalism leads to the proletarian revolution whereby the “dictatorship of the proletariat” is established.
Poverty will disappear. The state will “wither away” and each individual will contribute to national
income according to his abilities and receive according to his needs. Capitalism falls and socialism
replaces capitalism

A CRITICAL APPRAISAL
Marx’s theory of capitalist development has been accepted by his followers as a gospel truth while it has
been severely criticised by his opponents for the following reasons:
l. Surplus Value Unrealistic. The whole Marxian analysis is built on the theory of surplus value. In the
real world, we are concerned not with values but with real tangible prices. Thus Marx has created an
abstract and unreal value world which has made it difficult and cumbersome to understand the working of
capitalism.
2. Marx-A False Prophet. Marx has proved to be a false prophet. No doubt socialist societies have come
into existence but their evolution has not been on the lines laid down by Marx. The countries which have
toed the Marxian line of thinking have been curiously those in which capitalist development lagged
behind. All the communist states had been poor and are even now so, as compared to the capitalist
countries. There is no increasing misery of labour in advanced capitalist societies as asserted by Marx.
On the contrary, real wages of workers have continued to rise. The workers have tended to become more
prosperous with capitalist development. And the middle class instead of disappearing has emerged as a
dominant class. There have been also no signs of the ‘withering away’ of the State in these countries
3. Technological Progress Helpful in Increasing Employment. Marx pointed out that with increasing
technological progress, the industrial reserve army expands. But this is an exaggerated view because the
long run effect of technological progress is to create more employment opportunities by raising aggregate
demand and income.
4. Falling Tendency of Profits not Correct. According to Joan Robinson, Marx’s “explanation of the
falling tendency of profits explains nothing at all.” Marx contends that as development proceeds, there is
an increase in the organic composition of capital which brings about a decline in the profit pate. But Marx
failed to visualize that technological innovations can be capital saving too, and that with a fall in capital
output ratios and increases in productivity and total output, profits can rise along with wages.
5. Marx could not Understand Flexibility in Capitalism. Marx also could not foresee the emergence of
political democracy as the protector and the preserver of capitalism. Democracy as a political system has
proved its resilience and adaptability to the changing times. The introduction of social security measures,
anti-trust laws and the mixed economies have given a lie to the Marxian prediction that capitalism
contains within itself the seeds of its own destruction.
6. Cyclical Theory Wrong. Marx emphasized that capital accumulation led to a reduction in the demand
for consumption goods and fall in profits. But he failed to realise that with economic development the
share of wages in aggregate income need not fall, nor the demand for consumer goods.
7. Static Analysis. Marx’s theory, though it sought to explain a dynamic process, was in the words of
Schumpeter, “unsuited for it, its two main props being (a) labour theory of value, and (b) a modified
version of subsistence theory of wages. Marx was analysing the problem of growth with the help of tools
which were essentially suited to static economic analysis.”
Conclusion. Despite these weaknesses, some of the. Marxian tools pertaining to his theory of economic
development have ever since become part and parcel of the theory of economic growth. Technological
progress and innovations are the main stay of any theory of economic development. Similarly, capital
accumulation is the fundamental ideal behind economic growth. Profits are still regarded as both the
hallmark of capitalist development and its Achilles’ heel. Marx showed that economic development does
not follow a smooth course but comes about in “fits and starts.” Business cycles are inevitable. He
pointed out that a state of under-consumption was the main cause of depression and that for stable growth
a proper balance between investment and consumption was essential. He also indicated that too low or
too high wages in relation to total output can adversity affect investment and thus stifle economic growth.
Industrial unemployment is also one of the major variables in his system. Thus, Marx was in a way
Keynes’ precursor.

The Schumpeterian Theory

INTRODUCTION
Joseph Alois Schumpeter first presented his theory of economic growth in Theory of Economic
Development published in German in 1911 (its English edition appeared in 1934) which was elaborated
and refined but in no way altered in any essential respect in his Business Cycles (1939) and Capitalism,
Socialism and Democracy (1942).

THE THEORY
To start with, Schumpeter assumes a perfectly competitive economy which is in stationary equilibrium. In
such a stationary state, there is perfect competitive equilibrium: no profits, no interest rates, no savings,
no investments and no involuntary unemployment. This equilibrium is characterised by what Schumpeter
terms the “circular flow” which continues to repeat itself in the same manner year after year, similar to the
circulation of the blood in an animal organism. In the circular flow, the same products are produced every
year in the same manner. “For every supply there awaits somewhere in the economic system a
corresponding demand. For every demand the corresponding supply.” In other words, all economic
activities are repetitive in a timeless economy. To Schumpeter, “The circular flow is a stream that is fed
from the continually flowing springs of labour-power and land, and flows in every economic period into
the reservoir which we call income, in order to be transformed into the satisfaction of wants.”
Development, according to him, “is spontaneous and discontinuous change in the channels of the circular
flow, disturbance of equilibrium, which for ever alters and displaces the equilibrium state previously
existing.”1 These ‘spontaneous and discontinuous’ changes in economic life are not forced upon it from
without but arise by its own initiative from within the economy and appear in the sphere of industrial and
commercial life. Development consists in the carrying out of new combinations for which possibilities
exist in the stationary state. New combinations come about in the form of innovations.
Innovations. An innovation may consist of: (1) the introduction of a new product; (2) the introduction of a
new method of production; (3) the opening up of a new market; (4) the conquest of a new source of supply
of raw materials or semi-manufactured goods; and (5) the carrying out of the new organisation of any
industry like the creation of a monopoly. According to Schumpeter, it is the introduction of a new product
and the continual improvements in the existing ones that lead to development.
Role of Innovator. Schumpeter assigns the role of an innovator not to the capitalist but to the
entrepreneur. The entrepreneur is not a man of ordinary managerial ability, but one who introduces
something entirely new. He does not provide funds but directs their use. The entrepreneur is motivated by:
(a) the desire to found a private commercial kingdom, (b) the will to conquer and prove his superiority,
and (c) the joy of creating, of getting things done, or simply of exercising one’s energy and ingenuity. His
nature and activities depend on his social-cultural environment. To perform his economic function, the
entrepreneur requires two things: first, the existence of technical knowledge in order to produce new
products; second, the power of disposal over the factors of production in the form of credit. According to
Schumpeter, a reservoir of untapped technical knowledge exists which he can make use of. Therefore,
credit is essential for development to start.
Role of Profits. An entrepreneur innovates to earn profits. Profits are conceived “as a surplus over costs:
a difference between the total receipts and outlay–as a function of innovation.” According to Schumpeter,
under competitive equilibrium the price of each product just equals its cost of production, and there are
no profits. Profits arise due to dynamic changes resulting from an innovation. They continue to exist till
the innovation becomes general.
Breaking the Circular Flow. Schumpeter’s model starts with the breaking up of the circular flow with an
innovation in the form of a new product by an entrepreneur for the purpose of earning profits. In order to
break the circular flow, the innovating entrepreneurs are financed by bank-credit expansion. Since
investment in innovations is risky, they must pay interest on it. Once the new innovation becomes
successful and profitable, other entrepreneurs follow it in “swarm-like clusters.” Innovations in one field
may induce other innovations in related fields. The emergence of a motor car industry may, in turn,
stimulate a wave of new investments in the construction of highways, rubber tyres and petroleum
products, etc. But the spread of an innovation is never 100 percent.
The spread of innovation is shown in Fig. 1 where the percentage of firms adopting a particular
innovation is shown on the vertical axis and time taken on the horizontal axis. The curve OI shows that
firms adopt an innovation slowly to start with but soon the adoption of innovation gains momentum. But it
never reaches 100 per cent adoption by firms.

Cyclical Process. Since investment is assumed to be finance by creation of

bank credit, it increases money incomes and prices and helps to create a
cumulative expansion throughout the economy. With the increase in the
purchasing power of the consumers, the demand for the products of the old
industries increases in relation to supply. Prices rise, profits increase and old
industries expand by borrowing from the banks. It induces a secondary wave of
credit inflation which is superimposed on the primary wave of innovation.
Over-optimism and speculation add further to the boom. After a period of
gestation the new products start appearing in the market displacing the old products and enforcing a
process of liquidation, re-adjustment and absorption.2 The demand for the old products is decreased.
Their prices fall. The old firms contract output and some are even forced to run into liquidation. As the
innovators start repaying bank loans out of profits, the quantity of money is decreased and prices tend to
fall. Profits decline. Uncertainty and risks increase, the impulse for innovation is reduced and eventually
comes to an end. Depression ensues.
Schumpeter believes in the existence of the Kondratieff long-wave of upswings and downswings in
economic activity. Each long-wave upswing is brought about by an innovation in the form of a new
product which leads to further innovations in the methods of production, new forms of business
organisation, new sources of supply of raw materials and intermediate products, and new markets. Thus
there is abundance to goods available for the masses.” In the words of Schumpeter, “mass production
means production for the masses.” Once the upswings ends, the long-wave downswing begins and the
painful process of readjustment to the “point of previous neighbourhood of equilibrium” starts. Ultimately
the natural forces of recovery bring about a revival. Once again equilibrium is restored. Then smite
enterprising entrepreneurs begin with a new set of innovations, others follow, and a new boom begins.
Schumpeter describes this process of ‘capitalist development as one of “creative destruction” wherein the
old economic structures of society are being continually destroyed and the new structures are being
continually created in their place.
This is shown in Fig. 2 where time is taken on the horizontal axis and national output on the vertical axis. The curve
YPT shows the long-run cyclical upswings and downswings. When there is a new innovation, the economy
moves upwards from Y and production increases upto P. When this innovation ends and a new
innovation starts and replaces the earlier one the, output level falls from P to T. In
this way, “the creative destruction” process leads to the new equilibrium T of the
economy that is higher than the earlier point Y which shows the development of the
economy.

Schumpeter’s cyclical process of economic development is illustrated in Fig. 3 where the secondary
wave is superimposed on the primary wave of innovation. With over-optimism and speculation,
development proceeds more rapidly in the prosperity phase. When recession starts, the cycle continues
downward below the equilibrium level to the depression phase. Ultimately, another innovation brings
about revival. In fine, entrepreneurs are the key figures in the Schumpeterian analysis.
They bring about economic development in spontaneous and discontinuous manner. And “cyclical swings
are the cost of economic development under capitalism,” a permanent feature of its dynamic
time-path. Secularly, continued technological progress will result in an unbounded
increase in total and per capita output, since historically there are no
diminishing returns to technological progress. As long as technological
progress takes place, the rate of the profit will be positive. Hence there
can be no drying up of sources of investible funds nor any vanishing of
investment opportunities.
“There is therefore no a priori ceiling to the level of per capita income in a
capitalist society. Nonetheless, the economic success of capitalism will eventually lead to its decay. For
the very process of capitalist development weakens the institutions and values basic to its own
survival.”2 “Can capitalism survive? No, I do not think it can,” wrote Schumpeter, as his final appraisal
of the future of capitalism. To him, the very success of capitalism “undermines the social institutions
which protect it, and “inevitably” creates conditions in which it will not be able to live and which
strongly point to socialism as the heir apparent.”3

Process of End of Capitalism. According to Schumpeter, capitalism can maintain itself only so long as
entrepreneurs behave like knights and pioneers. But such daring innovators are being destroyed by the
capitalist system itself which rests on a rational attitude. This enquiring, sceptical and rational attitude
permeates the entire capitalist society. As a result, three forces are discernible that are the beginning of
the creeping death of capitalism. They are: (1) the decadence of the entrepreneurial function; (2) the
disintegration of the bourgeois family; and (3) the destruction of the institutional framework of the
capitalist society.
In the early stages of capitalism, the driving force came from entrepreneurs who dared to innovate, to
experiment, and to expand. But now innovation is reduced to a routine. Technological progress has
become the business of teams of trained specialists. The new ‘lords’ of business are the managers,
depersonalized owners and private bureaucrats. This reduces the industrial bourgeoisie to a class of
wage-earners and thus undermines the function and the position of the entrepreneur as the “warrior
knight.”
There is also the destruction of the bourgeoisie family. Parents adopt a rationalistic attitude in their
behaviour towards children. The traditional family idea is weakened. The desire to found a “private
kingdom” , a “dynasty” is no longer there. The will to accumulate wealth gradually disappears and along
with it another important aspect of the capitalist society.
Finally, Schumpeter contends that the entrepreneur also tends to destroy the institutional framework of the
capitalist society. The tendency towards concentration into big concerns weakens and destroys the twin
institutions of private property and freedom of contract. In the case of big concerns, the proprietors are the
small and large shareholders who are “dematerialized” and “defunctionalized” by the professional,
salaried managers. The proprietors’ role is performed by the latter while the former are totally divorced
from active management. According to Schumpeter, it was rationality that had destroyed the royal power
in the past. Now again, it is the rationalistic attitude of the ruling group towards domestic and
international problems that will be the bane of capitalism. But all these forces are not enough to ring the
death knell of capitalism. It is, however, the active hostility of the intellectuals which is bringing the day
nearer. The intellectuals sow seeds of doubt and discontentment in the minds of the masses against the
social and political framework of the capitalist order. By inciting the white-collar groups and the
labouring classes they are able to secure anti-capitalist political reforms. As a result, the institutional
framework upon which capitalism rests starts crumbling and there is a gradual movement towards
socialism. Eventually capitalism would fade away without any bang or whimper.

Rostow’s Stages of Economic Growth

Prof. W.W. Rostow has sought an historical approach to the process of economic development. He
distinguishes five stages of economic growth, viz., (1) the traditional society; (2) the pre-conditions for
take-off; (3) the take-off; (4) the drive to maturity; and (5) the age of high mass-consumption.

THE TRADITIONAL SOCIETY

A traditional society has been defined as “one whose structure is developed within limited production
functions based on pre-Newtonian science and technology and as pre-Newtonian attitudes towards the
physical world.”1 This does not mean that there was little economic change in such societies. In fact,
more land could be brought under cultivation, the scale and pattern of trade could be expanded,
manufactures could be developed and agricultural productivity could be raised along with increase in
population and real income. But the undeniable fact remains that for want of a regular and systematic use
of modern science and technology ‘a ceiling existed on the level of attainable output per head. It did not
lack inventiveness and innovations, but lacked the tools and the outlook towards the physical world of the
post-Newtonian era.
The social structure of such societies was hierarchical in which family and clan connections played a
dominant role. Political power was concentrated in the regions, in the hands of the landed aristocracy
supported by a large retinue of soldiers and civil servants. More than 75 per cent of the working
population was engaged in agriculture. Naturally, agriculture happened to be the main source of income of
the state and the nobles, which was dissipated on the construction of temples and other monuments, on
expensive funerals and weddings and on the prosecution of wars.

THE PRE-CONDITIONS FOR TAKE-OFF

The second stage is a transitional era in which the pre-conditions for sustained growth are created. The
pre-conditions for sustained growth were created slowly in Britain and Western Europe, from the end of
the 15th and the beginning of the 16th centuries, when the Medieval Age ended and the Modern Age
began. The pre-conditions for take-off were encouraged or initiated by four forces: The New Learning or
Renaissance, the New Monarchy, the New World and the New Religion or the Reformation. These forces
led to ‘Reasoning’ and ‘Scepticism’ in place of ‘Faith’ and ‘Authority’, brought an end to feudalism and
led to the rise of national states; inculcated the spirit of adventure which led to new discoveries and
inventions and consequently the rise of the bourgeoisie—the elite—in the new mercantile cities. Thus
these forces were instrumental in bringing about changes in social attitudes, expectations, structure and
values. Generally speaking, the preconditions arise not endogenously but from some external invasion.
For example, the pre-conditions ended in Europe (excluding Britain) with the domination of Napoleon
Bonaparte whose victorious armies set in motion new ideas and attitudes which brought about changes in
the structure of traditional societies and paved the way for the unification of Germany and Italy.
In any case, the process of creating pre-conditions for take-off from traditional society follows along
these lines:
“The idea spreads that economic progress is possible and is a necessary condition for some other
purpose, judged to be good; be it national dignity, private profit, the general welfare, or better life for the
children. Education for some at least, broadens and changes to suit the needs of modern activity. New
types of enterprising men come forward in the private economy, in government, or both, willing to
mobilize savings and to take risks in pursuit of profit to modernization. Banks and other institutions for
mobilizing capital appear. Investments increase, notably in transport, communications and in raw
materials in which other nations may have an economic interest. The scope of commerce, internal and
external, widens. And here and there, modern manufacturing enterprise appears, using the new methods.”2
The pre-conditions for sustained industrialization, according to Rostow, have usually required radical
changes in three non-industrial sectors:
First, a build-up of social overhead capital, especially in transport, in order to enlarge the extent of the
market, to exploit natural resources productivity and to allow the state to rule effectively.
Second, a technological revolution in agriculture so that agricultural productivity increases to meet the
requirements of a rising general and urban population.
Third, an expansion of imports, including capital imports, financed by efficient production and marketing
of natural resources for exports.
The continuous development and expansion of modern industry was mainly possible by the ploughing
back of profits into fruitful investment channels. As Rostow says: “The essence of the transition can be
described legitimately as a rise in the rate of investment to a level which regularly, substantially and
perceptibly outstrips population growth.”
The role of social and political factors in creating pre-conditions has already been explained in the
beginning of this ‘stage’. But the political forces deserve further explanations with reference to
underdeveloped countries and colonial territories.
It was “reactive nationalism”—reaction against the fear of foreign domination which acted as a potent
force in bringing about the transition. In Japan it was the demonstration effect, not of high profits or new
manufactured consumer’ goods, but of the Opium War in China in the early 1840’s and Commodore
Perry’s seven black ships, a decade later, that cast the die for modernization.
But in the colonies, the policy followed by the colonial powers to build up social overhead capital,
ostensibly to meet its own requirements, helped in moving the traditional society along the transitional
path. The spread of modern education brought about a gradual transformation in thought, knowledge and
attitude of the people, and a growing spirit of nationalism started resenting the colonial rule. Lastly, under
the influence of a powerful international demonstration effect, people wanted the products of modern
industry and modern technology itself.

THE TAKE-OFF

The take-off is the ‘great watershed’ in the life of a society “when growth becomes its normal condition. .
., forces of modernization contend against the habits and institutions. The value and interests of the
traditional society make a decisive breakthrough; and compound interest gets built into the society’s
structure.” By the phrase ‘compound interest’ Rostow implies ‘that growth normally proceeds by
geometric progression, such as a saving account if interest is left to compound with principal.’ At another
place, Rostow defines the take-off “as an industrial revolution, tied directly to radical changes in the
methods of production, having their decisive consequence over a relatively short period of time.”
The take-off period is supposed to be short, lasting for about two decades. Rostow has given the
following tentative take-off dates for those countries which are considered to be airborne:

Country Take-off Country Take-off

Great Britain 1783-1802 Japan 1878-1900
 France 1830-1860 Russia 1890-1914
Belgium 1833-1860 Canada 1896-1914
United States 1843-1860 Argentina 1935
Germany 1850-1873 Turkey 1937
Sweden 1868-1890 India & China 1952

Conditions for Take-off. The requirements of take-off are the following three related but necessary
conditions:
“(1) A rise in the rate of productive investment from, say, 5 per cent or less to over 10 per cent of
national income or net national product;
(2) the development of one or more substantial manufacturing sectors with a high rate of growth;
(3) the existence or quick emergence of a political, social and institutional framework which exploits the
impulses to expansion in the modern sector and gives to growth an outgoing character.”3

Let us examine these conditions in detail.

(1) Rate of Net Investment over 10 per cent of National Income. One of the essential conditions for
take-off is that the increase in per capita output should outstrip the growth of population to maintain a
higher level of per capita income in the economy. As Rostow explains: “If we take the marginal
capital/output ratio for economy in its early stages of economic development at 3.5:1 and if we assume, as
is not abnormal, a population rise 1-1.5 per cent annum it is clear that something between 3.5 and 5.25
per cent of NNP must be regularly invested if NNP per capita is to be sustained. An increase of 2 per cent
per annum in NNP per capita requires, under these assumptions that something between 10.5 and 12.5 per
cent of NNP be regularly invested. By definition and assumption, then, a transition from relatively
stagnant to substantial regular rise in NNP per capita under typical population conditions, requires that the
proportion of national product productively invested should move from somewhere in the vicinity of 5 per
cent to something in the vicinity of 10 per cent.”4
The typical case explained by Rostow is based on the supposition that the incremental capital-output ratio
and the rate of population growth remain constant. It thus precludes the effects of increased labour force
and improved technology on national income. However, during the take-off capital-output ratio tends to
decline with the change in investment pattern and a rise in the proportion of net investment to national
income takes place from 5-10 per cent, thus definitely outstripping the growth of population.

(2) Development of Leading Sectors. Another condition for take-off is the development of one or more
leading sectors in the economy, Rostow regards the development of leading sectors as the ‘analytical
bone structure’ of the stages of economic growth. There are generally three sectors of an economy:

(a) Primary Growth Sectors, where possibilities of innovation or of exploiting new or unexplored
resources lead to a higher growth rate than in the rest of the economy. The cotton textiles of Britain and
New England in the early stages of growth fall into this category.

(b) Supplementary Growth Sectors, where rapid growth takes place as a consequence of development
in the primary growth sectors. For example, the development of railways is a primary growth sector and
the expansion of iron, coal and steel industries may be regarded as a supplementary growth sector.
(c) Derived Growth Sectors, where growth takes place “in some fairly steady relation to the growth of
total income, population, industrial production or some overall modestly increasing variable.” For
example, the production of food and the construction of houses in relation to population.
Historically, these sectors have ranged from textiles in Britain and New England to railways in the United
States, the USSR, Germany and France; to modern timber cutting in Sweden. In addition, modern
agriculture also forms part of the leading sectors. For example, the rapid growth of Denmark and New
Zealand has been due to the scientific production of bacon, eggs, and butter, and mutton and butter
respectively. Thus, “there is clearly, no one sectoral sequence to take-off, no single sector which
constitutes the magic key.
According to Rostow, the rapid growth of the leading sectors depends upon the presence of four basic
factors:
First, there must be an increase in the effective demand of their products generally brought about by
dishoarding, reducing consumption, importing capital or by a sharp increase in real incomes.
Second, a new production function along with an expansion of capacity must be introduced into these
sectors.
Third, there must be sufficient initial capital and investment profits for the take-off in these leading
sectors
Lastly, these leading sectors must introduce expansion of output in other sectors through technical
transformations.

(3) Cultural Framework that Exploits Expansion. The last requirement for
take-off is the existence or emergence of cultural framework that exploits the
impulses to expansion in the modern sector. A necessary condition for this is
the ability of the economy to mobilize larger savings out of an expanding
income to raise effective demand for the manufactured products, and to
create external economies through expansion of leading sectors. As Rostow
says, “Take-off requires the massive set of pre-conditions, going to the heart
of a society’s economic organization, its politics and its effective scale of
values. . . . It usually witnesses a definitive social, political and cultural
victory of those who would modernize the economy over those who would
either cling to the traditional society or seek other goals....By and large, it
persuades the society to persist and to concentrate its efforts on extending the tricks of modern technology
beyond the sectors modernized during the take-off.”5
The take-off stage is explained in Fig. 1. The horizontal axis represents NNP and the vertical axis the
amount of saving, net investment and capital. S is the saving schedule. K0Y0 and K1 Y1 are the curves of
capital-output ratio drawn as downward sloping to simplify the figure. They are drawn parallel to each
other to indicate a constant capital-output ratio, i.e., OK O /OYO = OK1/OY1. TYO /YOY1 is the
marginal
capital-output ratio.
To start with, the society has a very flat saving curve and a very steep capital-output ratio curve in the
pretake-off stage. It implies that people save little out of their income and the capital-output ratio is very
high. In the time period 0, as OI0 net investment is made it tends to increase the capital stock which
becomes productive in time period 1 and raises NNP to OY1. Then in the take off stage when OI
1(=T1Y1) investment takes place, some major stimulus leads to the growth of the productive capital more
quickly leading to a fall in the capital-output ratio to T1Y1/Y1Y2. As a result, the investment pattern
changes and the capital-output ratio curve becomes flatter. It is T1Y2. NNP increases to OY2 which
further
raises net investment to OI2(=T2Y2). The economy has taken off, and if this pattern of growth is
continued
it will become self-sustained.
Thus, the take-off is initiated by a sharp stimulus, such as the development of a leading sector or a
political revolution which brings an outgoing change in the production processes, a rise in proportion of
net investment to over 10 per cent of national income outstripping the growth of population.

THE DRIVE TO MATURITY

Rostow defines it “as the period when a society has effectively applied the range of (then) modern
technology to the bulk of its resources.” It is a period of long sustained economic growth extending well
over four decades. New production techniques take the place of the old ones. New leading sectors are
created. Rate of net investment is well high over 10 per cent of national income. And the economy is able
to withstand unexpected shocks.

Great Britain 1850 Sweden 1930

UnitedStates 1900 Japan 1940
Germany 1910 Russia 1950
France 1910 Canada
1950

When a country is in the stage of technological maturity, three significant changes take place:

First, the character of working force changes. It primarily becomes skilled. People prefer to live in urban
areas rather than in rural. Real wages start rising and the workers organize themselves in order to have
greater economic and social security.
Second, the character of entrepreneurship changes. Rugged and hardworking masters give way to polished
and polite efficient managers.
Third, the society feels bored of the miracles of industrialization and wants something new leading to a
further change.

THE AGE OF HIGH MASS-CONSUMPTION

The age of high mass-consumption has been characterised by the migration to suburbia, the extensive use
of the automobile, the durable consumers goods and household gadgets. In this stage, “the balance of
attention of the society is shifted from supply to demand, from problems of production to problems of
consumption and of welfare in the widest sense.” However, three forces are discernible that tend to
increase welfare in this post-maturity stage.
First, the pursuit of national policy to enhance power and influence beyond national frontiers.
Second, to have a welfare state by a more equitable distribution of national income through progressive
taxation, increased social security and leisure to the working force.
Third, decision to create new commercial centres and leading sectors like cheap automobiles, houses,
and innumerable electrically operated household devices, etc.
The tendency towards mass consumption of durable consumer goods, continued full employment and the
increasing sense of security has led to a higher rate of population growth in such societies.
Historically, the United States was the first to reach the age of high mass consumption in 1920’s,
followed
by Great Britain in 1930’s, Japan and Western Europe in 1950’s and the Soviet Union after the death of
Stalin.

CRITICISM OF THE STAGES OF ECONOMIC GROWTH

“Rostow’s The Stages of Economic Growth is the most widely circulated and highly commented piece
of
economic literature in recent years. Economists are one in doubting the authenticity of the division of
economic history into five stages of growth’ as presented by Rostow. Are these ‘stages’ inevitable like
birth and death or do they follow a set ‘sequence’ like childhood, adolescence, maturity and old age? Can
one tell with sufficient precision that one stage is complete and the other has begun? To maintain that
every economy follows the same course of development with a common past and the same future is to
overschematize the complex forces of development and to give the sequence of stages a generality that is
unwarranted.”6
Let us comment on these ‘stages’ in detail.
(1) Traditional Society not Essential for Development. A number of nations such as the United States,
Canada, New Zealand and Australia were born free of traditional societies and they derived the pre-
conditions from Britain, a country already advanced. So it is not essential for growth that a country must
pass through the first stage.
(2) Pre conditions may not Precede the Take-off. In the case of ‘preconditions’, it is not necessary that
they must precede the take-off. For example, there is no reason to believe that an agricultural revolution
and accumulation of social overhead capital in transport must take place before the take-off.
(3) Overlapping in the Stages. In fact, the experience of most countries tells us that development in
agriculture continued even in the take-off stage. The take-off in the case of New Zealand and Denmark is
attributed to agricultural development. Similarly, social overhead capital in transport, especially in
railways, has been one of the leading sectors in the take-off, as Rostow himself tells us. It shows that
there is considerable overlapping in different stages.
(4) Criticism of the Take-off. The most widely discussed and controversial stage is the take-off. As
Cairncross has stated: “The stage that has struck the public mind most forcibly is undoubtedly that of the
take-off. Largely, no doubt, because the aeronautical metaphor— prolonged in the phrase “into self-
sustained growth”—suggests at once an effortlessness and finally congenial to modern thought. The
reactions of historians and economists have been less favourable. They have grown accustomed to
emphasizing the continuity of historical change, to tracing back to a previous age the forces producing a
social explosion and to explaining away the apparent leaps in economic development. They are inclined,
therefore, to regard Rostow as a latter day Toynbee, stressing a discontinuity that is no more than
symptomatic of the underlying forces at work and making the symptoms more decisive than they really
were.
(5) The Stage of Drive to Maturity Puzzling and Misleading. It contains all the features of the take-off
rate of net investment over 10 per cent of national income, development of new production techniques,
leading sectors and institutions. Then where lies the need for a separate stage where the growth process
becomes self-sustained. It can be self-sustained even in the take-off stage. In fact, as observed by
Kuznets,
“no growth is purely self-sustaining or self-limiting. The characterization of one stage of growth as self-
sustained and of others, by implication, as lacking that property, requires substantive evidence and
analysis not provided by Rostow.”11
(6) The Stage of High Mass Consumption not Chronological. The age of high mass consumption is so
defined that certain countries like Australia and Canada have entered this stage before even reaching
maturity. According to one critic, “the period of mass-consumption is nothing else but minus its
ideological overtone.

Cost benefit analysis

The most popular method of project evaluation is to consider the cost benefit analysis of
different projects and then to select involving lesser cost and yielding greater benefit.

The role of cost benefit is explained by Prof. Marglin as, “The perspective and Five year
Plans determine the broad strategy of growth by allocating resources among
sectors. But the strategy of growth embodied in the Plans leaves many tactical
questions unsolved, and it is these tactical decisions that are the province of cost
benefit cost analysis.”

It provides superior criteria for project evaluation in planned economy. It helps the planning
authority in making correct investment decisions to achieve optimum resource allocation by
maximising the difference between present value of benefits and costs of a project.

Thus, cost benefit analysis “purports to describe and quantify the social advantages and
disadvantages of a policy in terms of a common monetary unit.” The objective function can be
expressed as Net Social Benefit (NSB)=Benefits—Costs, where benefits and costs are measured
in terms of shadow or accounting prices of inputs and not of actual market prices.
2. Origin of Cost Benefit Analysis:
The origin of cost benefit analysis can be traced back to welfare economics of 19th century. The
first practical embodiment of the maximization of net benefit occurred in 1930s in the realm of
water resources. According to Flood Control Act of 1936, “The principle of comparing
benefits to whomsoever they may accrue with the estimated costs.” This reveals
unmistakably the social nature of the public investment decision.
The evaluation of federal expenditures in the field of navigation had been undertaken by the
Corps of Engineers. The Green Book of 1950 produced by the Federal Inter-Agency River Basin
Committee and the Bureau of Budget’s Budget Circular A-47 of 1952 made real attempt to instil
order into the diverse and loosely defined cost-benefit criteria.

In the 1950s academic interest in the CBA analysis was also growing. The real turning point
came, however in 1958 “with the simultaneous publication of works by Eckstein, Mckean and
Krutilla and Eckstein”. These publications attempted “to formalise public investment criteria in
relation to the established criteria of welfare economics.

Thus benefits were related back to the consumers’ surplus criteria of Dupuit, Marshall and
others, and ranking in terms of net social benefits was justified in terms of Pareto criteria for
welfare maximisation.”

3. Welfare Foundations of Cost Benefit Analysis:

The aim of cost benefit analysis is to channel resources into projects which will yield the greatest
gain in net benefit to society. Maximization of net benefit means the maximization of social
utility. Dupuit examined this problem first in 1844. Let us understand his arguments in fig. 1,
drawn under the assumption of perfect competition.
In Fig. 1, it is assumed that the undertaking of the project lowers the marginal cost from MC 1 to
MC2. Consequently, the market price is determined at D, the point of intersection of marginal
cost with the demand curve BQ. At the new price, consumers are willing to pay OBDE for the
quantity OE. The area OBDE consists of two parts—OHDE, the amount actually paid and HBD,
the extra amount they are willing to pay, called Consumer’s Surplus.
At C, the total price which the consumers were willing to pay was OBCK. So the change in the
willingness to pay as a result of lower price is KEDC. In other words, the lower price increases
gross benefits by the area KEDC.

The increase in benefits involves extra costs of KEDF. Hence the net gain in benefits is the
triangle FDC. This triangle consists of two parts, GCD and GFD. GCD is the gain in consumer’s
surplus whereas GFD is the gain in producer’s surplus.

Dupit suggested that the use of combined surplus in order to measure change in welfare arising
from the imposition of a toll on a bridge crossing. But this analysis can be extended to the case of
new investment.

Marshall later adopted consumer’s surplus concept to measure the change in welfare under the
restrictive assumption of constant marginal utility of income. Other assumptions of this analysis
were the cardinal indicators of utility gains and losses and identical utility scales for each person.
Under these assumptions there was no problem in adding up individual surpluses and losses.

Cardinal utility came under severe attack at the hands of ordinalists. Hoteling and Hicks argued,
that consumer’s surplus concept can still be retained by dropping the assumptions of cardinal
utility and constancy of marginal utility of income.

Pareto described a state in which no one person could be made better off without someone else
being made worse off. So if a change in economic organisation that makes everyone better off, or
more precisely, that makes one or more members of society better off without making anyone
worse off, is a Pareto improvement.

Since interpersonal comparison of utility is ruled out by ordinalists, Pareto optimum cannot
analyse a situation in which a change benefits some persons and harms others. Moreover,
Kaldor-Hicks compensation principle is an attempt to use Paretian optimum to explain this
situation.
A change which produces gains that exceed in value of the accompanying losses is an
improvement. In other words, a change increases social welfare if it is such that gainers can fully
compensate all the losers and yet remain better off than before.

Welfare foundations of cost-benefits analysis, whether the consumer’s surplus approach or the
Pareto optimum approach, are not of much value.

They are based on a number of very restrictive assumptions. Consumer’s surplus approach, even
stripped of its cardinal utility assumption, is useless on the ground, as indicated by Little, that
the demand curve is only partial and fails to consider the effect of investment on the prices of all
other goods.

Thus changes in surplus that may occur elsewhere are not taken into account in the analysis of
the project in question.

Pareto improvement ignores the resulting change in the distribution of incomes. “Not only is it
true that not everyone is made better off, it is also possible that those is the
community who are made worse off are to be found largely among the lower-
income group.” Suppose a change makes the rich better off by Rs. 3,00,000 at the expense of
the poor who are made worse off by Rs. 2,00,000.
There is an excess gain of Rs. 1,00,000 for the society as a whole. But such an economic change
which worsens the inequality in income distribution may not be acceptable to the majority
opinion. Kaldor Hicks compensation principle is no solution of this problem since it considers
only hypothetical payment to losers.

4. Application of Market Principle:

1. Maximization of Total Benefit-Fixed Budget:
(i) Divisible Projects:
If we assume that projects are divisible, the task is simple when a unit of money is spent on
project X, its opportunity cost is the benefit lost from not spending it on project Y, and vice-
versa. Net benefit is the maximum when total benefits minus total costs are the highest. This is
attained if MBx/MBy = MCx/MCy.
Let us suppose that a total sum of G is to be spent on two projects X and Y. If G is divided
between them in such p way that OM is spent on X and ON on Y, total benefit is the highest since
marginal benefit PM from OM equals marginal benefit PN from ON. It will be so under the
assumption that MC is equal to one rupee and so MBx should be equated to MBy. It can be
shown in fig. 2.

In fig. 2, OM + ON = G the fixed budget. Total benefits from X are OMPS and those from Y are
ONP1L. Marginal benefit from X is PM and that from Y is P1N and they are equal. Since MC in
both cases equals rupee one. PM = P1N. Thus, the condition MBx/MBy = MCx/MCy is met.
(ii) Lumpy Projects:
In the case of lumpy projects, that is, allocation of funds between broad expenditure categories
(e.g. between government departments), marginal approach is not applicable.

If we compare total benefits from each project and choose the most profitable ones or compare
total benefits with total costs and select those whose net benefits are the highest, we cannot get
the correct result because outlays on different projects are different.

Hence we have to rank the projects on the basis of B/C ratio. An alternative approach is to rank
the projects on the basis of B-C/C ratio—a ratio which gives a rate of return on cost. Rankings are
the same in both the cases.
In Table 1, cost for each project is measured by the rupee expenditure required. Benefit refers to
the total benefit of each project. In terms of Fig. 2, the total benefit of project Y is the area ONP1L
and it involves an outlay of ON. Cost and benefit of each project have been shown in similar ways
in the above table.
2. Maximization of Total Benefits-Variable Budget:
In the case of variable budget, two problems must be solved. One relates to the determination of
the size of the total budget and the other is concerned with the selection of public projects. In
this situation the opportunity cost of public projects needs to be redefined in terms of the
benefits lost from private projects which are foregone because resources are transferred to social
use.

If public projects are divisible, the task is the maximization of net benefits (SIGMAB – ∑C),
including benefits and costs of both public and private projects. This is attained when the
marginal benefit for last rupee spent on public project equals that on private project. Since the
marginal benefit from spending in the private sector equals Rs. 1, it holds for public sector as
well.

Let us now take the case of lumpy projects. The B/C ratio in the private sector is taken to equal 1.
The public project is undertaken if the B/C ratio exceeds 1, it, therefore, suggests that only
projects I, II and VI in Table 1 will be undertaken.

Our aim above has been to show that the level of resource-using activities of the government and
their allocation among different activities are determined by the same basic rule of optimum
resource allocation which applies to the private sector of the economy. This is the equality of
marginal social costs and benefits.
This rule requires that each government activity should be extended to that level at which the
marginal social benefits from the activity equal marginal social costs. The marginal social
benefits (MSB) are the gains to the members of the community as a whole from government
expenditure.

Marginal social costs (MSC) are taken as the benefits from private sector productions which are
foregone due to the transfer of resources to the public use. The optimum level of each public
activity is attained when MSB from all activities are equal to one another. The benefits to the
society from the last rupee spent on education, for instance, must be the same as those from the
last rupee spent on defence.

5. Financial Study and Cost Benefit Analysis:

While employing capital investment for production of an output, the decision is made on the
expected return on investment. If such return is anticipated to be less than in other lines of
production the particular product will not be able to attract capital from the investors.

In the case of public investment project, if the investment is made directly out of the proceeds
from government exchequer, the planners assume the responsibility of making available
adequate returns to the nation. In the case of private sector, investment involves such a
commitment to the stockholders in the form of dividends.

Thus, time element is a prominent factor for investment fund, since it involves sacrifice of
present consumption and waiting for future consumption. An individual will sacrifice his present
consumption against a promise of enhanced future consumption in accordance with what is
called his time preference.

If he is indifferent as between one rupee worth of present consumption and one rupee ten paise
worth of consumption one year hence, the rate of his marginal time preference is 0.10 or 10 per
cent. This fact can be explained with the help of fig. 3.
In fig. 3, curve shows possibility of capital productivity or investment opportunities. The slope of
the curve at different points or what is technically called Marginal Rate of Transformation (MRT)
indicates the rate at which present income can be transformed into future income.

Thus, at point E the rate is given by the slope of the line DC indicating that the present income of
the amount AM can be transformed into future income of the amount EM.

The greater the sacrifice of present income, the larger will be the amount of transformed future
income. But the rate of returns from sacrificing present income is diminishing and hence is the
transformation curve concave to the point of origin.

On the other hand, marginal rate of time preference of the individual is given by the slope of his
indifference curve for present consumption and future consumption. It indicates the rate at
which he is ready to sacrifice present consumption against an assured amount of future
consumption.

If at a point of indifference surface the slope indicates larger present consumption than future
consumption, the marginal rate of time preference will be negative as shown by P 3 schedule with
KL slope. In the reverse case as indicated by the slope line DC at point E of indifference schedule
P1 the rate will be positive while GF slope of P2 speaks of neutral preference or zero rate.
The marginal rate of time preference and the marginal rate of transformation are equal at point
E where the preference and transformation schedules are tangent to each other. At this point, the
rate of interest in private economy is determined.
6. General Conditions for Cost Benefit Analysis:
The project selection must be made on cost benefit analysis to formulate optimal development
plans. The first step of project evaluation is to consider a list of cost and benefits of a project. It
depends upon the nature of the project. The social benefits of a project include the contribution
that the project would make to the attainment of national goals.

7. Criteria for Cost Benefit Analysis:

There are four benefit cost criteria discussed by the US Sub- Committee on benefits and costs.

They are:
(i) B—C

(ii) B—C/I

(iii) ∆B/∆C

(iv) B/C

Where B—Benefits, C—Costs, I—Direct Investment, ∆—Increment

The formula B—C/I is “for determining the total annual returns on a particular investment to the
economy as a whole irrespective of to whom these accrue”. If the private investment happens to
be very large, then even high value of B—C/I may be less beneficial to the economy. Thus, this
criterion is not much useful to achieve satisfactory results. The another criterion of ∆B/∆C is
meant to determine the size of project.

The adoption of the B—C criterion favours a large project and makes small and medium size
projects less beneficial. Thus, this criterion helps in determining the scale of project on the basis
of the maximisation of the difference between B and C. The best and most effective criterion for
project evaluation is B/C.

In this criterion, the evaluation of project is done on the basis of benefit-cost ratio. If B/C=1, then
the project is marginal because the benefits occurring from the project just cover the costs. If
B/C, then benefits are less than costs-so the project is rejected. If B/C=1, the benefits are more
than costs and the project is profitable and hence, it is selected. The higher the benefit cost ratio,
more profitable will be the project.
The criterion discussed above does not account for the time factor. In fact, the future benefits
and costs cannot be treated at par with present benefit and cost. Therefore, project evaluation
requires discounting of future benefits and costs because society prefers present to the future.
For this purpose, the economists have derived a number of decision rules or criteria.

They are discussed below:

1. The Net Present Value (NPV) Criterion:
This is an important criterion for project evaluation. NPV=Present value of benefit—Present
value of operating and maintaining costs—Initial outlay. It is also expressed as the net present
value of benefits criterion so that,

NPV of benefit = Gross present value of benefits—Gross present value of costs.

If NPV > O then the project is socially profitable. If there are number of mutually exclusive
projects, then the project with the highest net present value of benefits will be chosen.

The NPV criterion is not accurate method for project evaluation as it neglects the time horizon.
Capital investments give benefits after a lapse of some time. Therefore, future benefits and costs
cannot be equated with present benefits and costs. So it becomes essential to discount future
benefits and costs because society prefers present to future.

The discount factor is expressed as:

Only those projects should be selected in which present value of benefits exceeds the present
value of costs i.e.
The ratio of present value of benefit to present value of cost should be greater than 1 for the
selection of a project i.e.

2. The Internal Rate of Return Criterion:

The criterion refers to the percentage rate of return implicit in the flows of benefits and costs of
projects. Margin defines the internal rate of return (IRR) as the discount rate at which present
value of return minus cost is zero. The mathematical formula for the computation IRR is (IRR)

In case of mutually exclusive projects, the project to be selected must have highest rate of return.

But this criterion has certain limitations which are given below:
1. It is not possible to change the rate of return assumed for the calculation of profitability of
project.

2. It is difficult to calculate rate of return on long gestation project which does not yield benefit
for many years.

3. This criterion is not applicable to highly capital intensive projects.

4. It is difficult to calculate IRR in which the entire investment outlay cannot be made in first
period.

5. The use of IRR for public investment does not lead to correct decisions because it is not
possible to discount intermediate benefits and costs of public investment at internal rate of
return.

6. It is difficult to make choice between two alternative investments on the basis of their
alternative internal rates of return.
7. Layard points out the problem of capital rationing where projects cannot be selected on the
basis of ranking in order of the rate of return. Such projects can only be selected on the basis of
their net present value.

In fact, IRR depends upon social rate of discount. The choice of project depends upon discount
rate if net present values of the projects are given. This can be explained with the help of a
diagram 4.

The rate of discount is measured along X-axis and NPV on Y-axis. The curve II1 depicts
investment of project I and QQ1 of project Q. The IRR of project Q is higher than of project I
because discount rate or is greater than Or1. At Oq2, the IRR of both projects are equal. But if
discount rate falls below Oq2, project I will be chosen because its NPV is higher by ik. The choice
on the basis of changes in discount rate is called Switching and Re-switching.
Relation between NPV and IRR:
The NPV at the social discount rate and the internal rate of return are two criteria which are
frequently used for choosing projects. The relation between NPV and IRR is illustrated with the
help of a diagram 5.
As NPV falls, the discount rate increases and a situation arises when NPV becomes negative. The
rate at which NPV changes from positive to negative is IRR. For the selection of project, the IRR
must be higher than its discount rate i.e. r > i.

In the above figure, IRR is taken as 10 per cent be selected for development so long as NPV > O
and r (10 per cent) > i (5 per cent). For complex projects, these two criteria can give different
results but mostly they are interchangeable.

NPV criterion is commonly used for project evaluation in private and public sectors. But the NPV
criterion is technically superior, since IRR can give an incorrect result in special circumstances.

3. Social Rate of Discount (SRD):

Since society prefers present to future, so future generations are likely to have higher levels of
income. If the principle of diminishing marginal utility operates, then the utility gains to future
generations from a given amount of benefits will be less than the utility gains to the present
generations so the future gains must be discounted.

The rate at which future benefits must be discounted to make them comparable with present
benefit is called ‘Social Rate of Discount’. In other words, it is the rate of premium which the
society puts for preferring the present consumption to future consumption. This is illustrated
with the help of a diagram 6 given.
The present consumption A1 is taken along horizontal axis and future consumptions A2 taken
along vertical axis. A1A2 is the transformation frontier or investment possibility curve. It consists
of a series of projects arranged from right to left in order of their rate of return, the cost of
sacrifice of present consumption and the return is the gain of consumption in future.
The society will choose from the various investment possibilities so as to reach its highest social
indifference curve SI, The society reaches an optimal position when transformation curve
A1A2 equals its social indifference curve SI at point G.
The slope of the transformation curves represents the rate of return on investment and the social
indifference curve represents the rate of time preference. Thus, social discount rate is
determined by the equality of the rate of return on investment and rate of time preference at
point G.

The social discount rate is constant over time. “A discount rate of 5 per cent might well
lead to twice as much investment as one of the 10 per cent together with equivalent
reduction in consumption.” If the discount rate is high, short period projects with higher net
benefits are preferred. On the contrary, when the discount rate is low, long period projects with
lower net benefits are selected.
Since the benefits and costs are to occur in future, they are discounted in order to find their
present net worth so there is a problem of choosing suitable rate at which future benefits are
discounted.

Generally, the market rate is used for this purpose but it fails to solve the purpose where there is
multiplicity of rate of interest in the market or the private and social rate of discount may not
concede, hence there is no scientific way of choosing a suitable rate.
Pigour and Dobb regard the use of social time preference rate as ‘pure myopia’. They allege that
people are victims of “defective telescopic facility” that is why they prefer consumption to
future consumption. But they reject this view on the ground that society is a continuous entity
and it has collective responsibility for future generations.
So they favour zero social time preference rate because the present and future should have equal
weights in the estimation of the society. According to Marglin, this view is an “authoritarian
rejection of individual preferences”. Sen and Eckstein pointed out that the rational fear of death
is sufficient for people to have positive social time preference rate.

Hirschleifer and other use the concept of social opportunity cost to measure the social discount
rate. “The social opportunity cost is a measure of the value of society of the next best
alternative use to which funds employed in public project might otherwise have
been put.”
The next best alternative use of funds is investment in private sector. If they earn a rate of 6 per
cent, the public investment must also earn a rate of 6 per cent or more. Thus, social rate of
discount is 6 per cent. If the public project earns 6 per cent, it should not be undertaken.

Thus, the social opportunity cost method of calculating the social discount rate is not free from
certain shortcomings. Hence, it is difficult to find a rate of return which may measure the social
opportunity cost of funds. According to Feldstein, the social opportunity cost depends on the
sources of particular funds, it must reflect social time preference function.

He, therefore, suggests a method of combining the two. The procedure is to allow for the social
opportunity cost of funds directly by placing a shadow price on the funds used in the project and
to make all inter-temporal comparisons with social time performance rate.

On the other hand, Mishan suggested that if the government has the power to invest in private
sector, then the social opportunity cost rate can be used social rate of discount.

Marglin have argued for a synthetic discount rate. They pre-assumed that the social time
preference rate is less than social opportunity cost rate. Therefore, there will be under
investment in the economy which requires a synthetic discount rate for public investment. The
synthetic discount rate is some weighted average of the social time preference rate and the social
opportunity cost rate.
Baumol does not agree with Marglin that there should be synthesis of the two rates. He regards
the choice of rates as indeterminate because of the existence of risk and institutional barriers
which will prevent the two rates to be in equilibrium.

Pearce suggested that the correct answer to the choice of social discount rate does not lie in the
selection of single rate, but in the use of both the social time preference and the social
opportunity cost rates according to the type of benefits yielded and the type of forgone
expenditure.

He concluded that it would not matter which rate is chosen. If equilibrium conditions prevail,
the necessity for the estimation of a synthetic discount rate disappears.

8. Uses of Cost Benefits Analysis:

The uses of cost benefit analysis can be made on the following ground:
(a) Evaluation on the Basis of Benefit:
Benefits refer to the addition to the flow of national output resulting from investment in
particular project. Those projects are said to be profitable whose contribution to national output
is greater than those with a smaller contribution. Benefits may be real or nominal and direct or
indirect.

(i) Real Benefits:

In cost benefit analysis, we are concerned with real benefits rather than nominal benefits flowing
from a project. A river valley project may increase irrigational facilities to the cultivators but if at
the same time, the state levies heavy betterment levy on them, the benefit is nominal.

But if the same project besides increasing irrigational facilities raises productivity of land per
acre and leads to a number of other external economies whereby real income of the farmer rises,
then, it is said to lead to real benefits.

(ii) Direct and Indirect Benefits:

Direct benefits are those which can be obtained immediately and directly from the project and
indirect benefits are those which are more or less identical to direct benefits. The direct benefits
flowing from multipurpose project are flood control, irrigation, navigation, development of
fisheries etc.
But there may be also certain side effects of the project which may be categorised as indirect
benefits. For example, the construction of the Bhakra Nangal Project in Punjab has provided
employment opportunities to thousands of people. It led to the construction of new railway line
connecting Nangal Township and the Bhakra Nangal Dam with the rest of the country.

New roads have been laid. The Bhakra Nangal Dam has been developed into a tourist resort
thereby augmenting income. The direct and in direct benefits must be taken into consideration
while evaluating the project.

According to Prof. Bruton, “Project evaluation should take into account the effects of a
project on the rate of investment, on the growth rate of population, on the
acquisition of skills and managerial talents by the people.”
(iii) Tangible and Intangible Benefits:
Benefits flowing from a project may be tangible or intangible. Tangible benefits are those which
can be computed and measured in terms of money while intangible benefits cannot be measured
in monetary terms. For example, benefits flowing from the Bhakra Nangal Project are tangible
and can be computed.

Intangible benefits enter into individual valuations, for which there is neither a market nor a
price. They may be positive or negative.

(b) Evaluation on the Basis of Costs:

The calculation of cost of a project is very difficult because various types of costs are considered
in its construction. Costs mean the value of resources used in the construction of a project.

(i) Real and Nominal Costs:

Costs may be real or nominal as they involve real sacrifice on the part of people or otherwise not.
If money is borrowed from the people, it is a case of nominal cost. But if people are required to
construct project themselves, they will be incurring real sacrifice and then it will be case of real
cost.

(ii) Primary and Secondary Costs:

Primary or direct costs are those which are directly incurred on the construction of a project but
the secondary costs include the cost providing benefits to the people working on project such as
cost of constructing houses, schools, hospitals etc. at the sight of project.
(iii) Associated Costs:
They are the value of goods and services needed beyond these included in the cost of a project to
make immediate products or services of the project available for use or sale. For example, the
farmer’s cost of producing irrigated crops other than any charge for water would be his
associated costs of producing crops.

(iv) Project Costs:

These are the value of resources used in constructing maintaining and operating the project. This
includes cost of labour, capital, equipment, intermediate goods, natural resources and foreign
exchange etc.

9. Limitations of Cost Benefit Analysis:

Cost benefit analysis is a powerful technique regarding the selection and rejection of project even
then it is not free from drawbacks.

Some of its limitations are as under:

1. Difficulties in Benefit Assessment:
The correct estimation of benefits from a project also becomes difficult due to uncertainty
regarding the future demand and supply of the products from a new project and their prices.
Another difficulty arises from the existence of external economies.

The presence of external economies may lead to the selling of the product of project at price
equal to marginal cost and not equal to average cost which will create a deficit and efforts are
made by a special levy on consumers or through budgetary resources.

According to Prof. Lewis, “To calculate the true net social benefit of an investment calls for
skepticism as well as skill. The figures submitted to government almost always involve
exaggerated optimism and double counting. If one uses low shadow wage in valuing labour,
when calculating costs, one must not give extra a credit to the project also when calculating
benefits because it will relieve unemployment. Shadow prices may be applied to costs or to
benefits, the same item should not appear in both. Again annual values and capital values should
not be added together.”

2. Arbitrary Discount Rate:

The social rate of discount assumed for any project is arbitrary. There is no perfect method to
find social discount rate. It remains a subjective phenomenon. But if there is a small change in
social discount rate it may change the full results of project evaluation. The arbitrarily large
discount rate does not help in calculating the net present value of benefits of long term projects.

3. Ignores Opportunity Cost:

It also ignores the problem of opportunity cost. Griffin and Enos state that if all prices reflect
opportunity costs, all projects for which B/CI would be chosen.

4. Problem of Externalities:
The side effects of a project are difficult to calculate in this analysis. There may be technological
and pecuniary externalities of a river valley project, such as the effects of flood control measures
or a storage dam on the productivity of land at other places in the vicinity.

5. Difficulties in Selecting Appropriate Decision Rules:

There are three decision rules for the evaluation of project. These are NPV criterion, IRR
criterion and SRD criterion. All these criterion have their own advantages and disadvantages.
Therefore, it becomes difficult to decide as to which criterion should be used for the evaluation of
the project because the wrong selection will lead to false conclusions.

6. Difficulties in the Cost Assessment:

Cost estimates are made on the basis of the choice of techniques, locations and prices of factor
services used. Market prices of factors of production are used for this purpose provided they
reflect opportunity cost.

But in underdeveloped countries, market prices usually do not reflect the opportunity costs,
because there is fundamental disequilibria which is reflected in the existence of massive under-
employment at the prevailing level of wages, the deficiency of funds at prevailing interest rates
and the shortage of exchange at current rates of exchange.

The equilibrium level of wage rates will be considerably lower than market wages while
equilibrium interest rates will probably be much higher than market rates. To remove this
difficulty, the use of ‘shadow prices’ or ‘accounting prices’ have been suggested by J. Tinbergen,
H.B. Chenery and K.S. Kretchmer.

These shadow prices reflect the intrinsic value of factors of production. In the cost benefit
analysis, we cannot take the opportunity cost of labour as zero.
7. Neglects Joint Benefits and Costs:
It ignores the problems of joint benefits and costs arising from a project. There are number of
direct and indirect benefits flowing from river valley project but is difficult to evaluate and
calculate such benefits separately. Similarly, the joint costs that cannot be separated are
calculated benefit-wise.

8. Adjustment for Risk and Uncertainty:

It is done in three ways, at the time of calculating the length of project life, the discount rate and
by making due allowance in benefits and costs. It is advantageous to use the Government
borrowing rate. The Research Programme Committee of the Indian Planning Commission
suggests 5 per cent as productivity rate and 10 per cent as capital scarcity rate.

Environmental Kuznets curve

Definition: The environmental Kuznets curve suggests that economic development initially
leads to a deterioration in the environment, but after a certain level of economic growth, a
society begins to improve its relationship with the environment and levels of environmental
degradation reduces.
From a very simplistic viewpoint, it can suggest that economic growth is good for the
environment.

However, critics argue there is no guarantee that economic growth will lead to an improved
environment – in fact, the opposite is often the case. At the least, it requires a very targeted
policy and attitudes to make sure that economic growth is compatible with an improving
environment.

Diagram of Kuznets Curve

Causes of Environmental Kuznets curve

1. Empirical evidence of declining pollution levels with economic growth.

Studies found that higher economic growth in the US led to increased use of cars, but at
the same time – due to regulation, levels of air pollution (in particular sulphur dioxide
levels declined). See: Kuznets curve a Primer
2. Spare income with growth. With higher rates of economic growth, people have more
discretionary income after paying for basic necessities; therefore, they are more
amenable to paying higher prices in return for better environmental standards.
3. Focus on living standards as opposed to real GDP. Traditional economic theory
concentrates on increasing real GDP and rates of economic growth. But there is a growing
awareness the link between economic growth and living standards can be weak. Focusing
on living standards can become politically popular.
4. Improved technology. The primary driving force behind long-term economic growth
is improved technology and higher productivity. With higher productivity, we can see
higher output, with less raw materials used. For example, since the 1950s, the technology
of car use has significantly improved fuel efficiency. In the 1950s, many cars had very low
miles per gallon. In recent years, car manufacturers have made strides in reducing fuel
consumption and have started to develop hybrid technology.
5. Solar and renewable energy. A good example of how improved technology has
reduced potential for environmental damage is the progress in solar technology. In recent
 years, the cost of solar energy has significantly fallen – raising the prospect of clean
technology. See: Solar technology
6. De-industrialisation. Initially, economic development leads to shifting from farming
to manufacturing. This leads to greater environmental degradation. However, increased
productivity and rising real incomes see a third shift from industrial to the service sector.
An economy like the UK has seen industrialisation shrink as a share of the economy. The
service sector usually has a lower environmental impact than manufacturing.
7. Role of government regulation. Economic growth and development usually see a
growth in the size of government as a share of GDP. The government are able to
implement taxes and regulations in an attempt to solve environmental externalities
which harm health and living standards.
8. Diminishing marginal utility of income. Rising income has a diminishing marginal
utility. The benefit from your first £10,000 annual income is very high. But, if income
rises from £90,000- £100,000 the gain is very limited in comparison. Having a very high
salary is of little consolation if you live with environmental degradation (e.g. congestion,
pollution and ill health). Therefore a rational person who is seeing rising incomes will
begin to place greater stress on improving other aspects of living standards.

Criticisms of Kuznets Environmental Curve

1. Empirical evidence is mixed. There is no guarantee that economic growth will see a
decline in pollutants.
2. Pollution is not simply a function of income, but many factors. For example, the
effectiveness of government regulation, the development of the economy, population
levels.
3. Global pollution. Many developed economies have seen a reduction in industry and
growth in the service sector, but they are still importing goods from developing countries.
In that sense, they are exporting environmental degradation. Pollution may reduce in the
UK, US, but countries who export to these countries are seeing higher levels of
environmental degradation. One example is with regard to deforestation. Higher-income
countries tend to stop the process of deforestation, but at the same time, they still import
meat and furniture from countries who are creating farmland out of forests.
4. Growth leads to greater resource use. Some economists argue that there is a degree
of reduced environmental degradation post-industrialisation. But, if the economy
continues to expand, then inevitably some resources will continue to be used in greater
measure. There is no guarantee that long-term levels of environmental degradation will
continue to fall.
5. Countries with the highest GDP have highest levels of CO2 emission. For
example, US has CO2 emissions of 17.564 tonnes per capita. Ethiopia has by
comparison 0.075 tonnes per capita. China’s CO2 emissions have increased from 1,500
million tonnes in 1981 to 8,000 million tonnes in 2009.

Conclusion
The link between levels of income and environmental degradation is quite weak. It is possible
economic growth will be compatible with an improved environment, but it requires a very
deliberate set of policies and willingness to produce energy and goods in most environmentally
friendly way.