Choice of Techniques in Production

The choice of techniques is an area of economics in
which the question of the

appropriate capital or labor-intensity of the method
of production of goods is discussed. In the context of
traditional development economics it was often
recognized (Stewart (1972) for example) that this
choice was central to development strategies and
that such choices were inter-twined with decisions
over the type of goods to be produced and the scale
of operation of an industry.
CHOICE OF TECHNIQUES, INVESTMENT CRITERIA AND
SOCIAL APPRAISAL OF PROJECTS
EFFICIENT OR OPTIMUM INPUT COMBINATION
The technique that maximises profit, given the relative prices of
factors is regarded as the most optimal.
CAPITAL
A
T
I
LABOUR
Figure 1: Optimum Input Combination
The isoquant I represents the different methods of producing

the same output (in terms of capital/labour ratios).
Factor availability is represented by the price-line AB.
The optimum input combination is shown at the point of
tangency T.
THE CAPITAL INTENSITY OF TECHNIQUES IN DEVELOPING
COUNTRIES
THEORY:
In situations of surplus labour and scarce capital, labour-intensive
techniques will be chosen.
CAPITAL
I
DC
c
LDC
b
LABOUR
Figure 2: Optimum Technical Choice in Developed and Less

Developed Countries (LDCs)
In the LDCs, the optimum K/L ratio is given by the ray, LDC;
While in the developed country, the optimum capital-labour ratio is
given by the ray, DC.
PRACTICE:
The capital-intensity of techniques is not very different between
developed and developing countries.
In the modern sector, in LDCs techniques are much more capitalintensive than would be predicted on the basis of our knowledge of
factor endowments.
EXPLANATIONS:
Technological choice in developing countries:
inappropriate choices
(a)
Reasons for
Technological rigidity. The production function may not be

smooth-shaped.
There may not exist a spectrum of techniques to choose from.
The production function may be L-shaped (Leontief Production
Function), implying fixed coefficients of production.
(b)
Input prices may fail to reflect relative factor availability.
Market prices of factors of production may not properly reflect

the abundance or scarcity of the relevant factors.
(c)
Wage costs per unit of output may differ very little between
developed and developing countries.
The Efficiency Wage (Wage Rate/Productivity of Labour) is
hardly different.
(d)
Labour-intensive techniques may require a great deal of

skilled labour, which is in short supply in LDCs.
(e)
Labour-Saving Bias in imported technologies.

LDCs lack the capital goods sector.
Technology innovation carried out in developed countries is of
the labour -saving type.
(f)
Dependence of foreign aid also often leads to the import of

capital-intensive technologies.
Tied foreign aid.
NEED FOR IMPROVED ALLOCATION METHODS

Inherent problems of applying commercial allocation criteria because
of
Externalities, decreasing cost industries, etc.;
Difficulties of quantifying many benefits;
Further complications because of price distortions.
EARLY APPROACHES FOR PROJECT SELECTION:
Use of Partial Investment Criteria
Two such criteria are:
1.
The minimum capital-output ratio criterion, advocated by J J

Polak (Balance of Payments Problems of Countries
Reconstructing with the Help of Foreign Loans, QJE 1941, and
N S Buchanan, International Investment and Domestic
Welfare, 1945. Quoted in A K Sen, Choice of Techniques,
1968, 3rd edition, p. 15).
2.
The marginal per capita reinvestment quotient criterion,

advocated by W Galenson & H Leibenstein (1955, Investment
Criteria, Productivity and Economic Development, QJE).
THE MINIMISING CAPITAL-OUTPUT RATIO CRITERION

Suggests for minimising capital intensity per employee, so that the
scarce factor, capital, is used in such a way that the rate-of-return
(defined as the ratio of output to capital) is maximised.
As investment funds are limited, those projects yielding highest value
of annual product relative to investment are selected first.
Y
4
K
2
1
0
Figure 3: Minimising Capital-Intensity per Employee

Labour is represented along the X-axis and capital along the
Y-axis. There are four product curves, each representing a
particular level of output of a commodity. Given the amount
of capital, OK, the maximum amount of output which can be
produced, by minimising the capital-intensity per employee,
is shown by the equal-product curve 3. The equal cost curve
touches the equal product curve 3 at point M. The optimum
capital-labour ratio is indicated by the slope of OM. OL
represents the amount of labour used.
6
It is apparent from Fig. 3 that a horizontal equal-cost curve, as

represented by KM is due to the assumption of zero labour cost.
THE MARGINAL PER CAPITA REINVESTMENT QUOTIENT

CRITERION
Resources ought to be allocated in such a way so as to maximise
output and consumption in the future.
The criterion encourages for minimising the use of labour so that
investible surplus per head of labour is maximised.
Consumption and labour use at present will be sacrificed to achieve
higher output in the future than would be possible.
The model, which makes a positive contribution by
reminding us that important income distributional
considerations should not be neglected, has attracted
serious
criticisms
particularly
because
of
its
unrealistic assumptions.
It is doubtful whether the MPS out of profits equals one.
It is also wrong to assume that the savings propensity out
of wages is zero.
Moreover, an increase in consumption through distribution
of income may be a social objective in which case it will
be wrong to ignore present consumption.
EMPLOYMENT versus SAVING
The potential conflict between employment and saving
emerges from the marginal per capita reinvestment quotient
criterion as advised by Galenson & Leibenstein (1955).
7
The conflict between employment and saving has also been

emphasised by Dobb (1955) and Sen (1968) who illustrated
it in its starkest form using a simple production function.
Diagrammatically,
Y
W
T
M
R
01
I
L
K
Z
Fig 4: Optimum Use of Labour with Given Capital
Labour is represented along the horizontal X-axis, output
along the vertical Y-axis above the origin and capital along
the vertical Z-axis below the origin. Assume that a fixed
amount of capital, OK, is used to produce a particular
commodity by varying the use of labour (the input of which
can be varied under our restrictive assumptions). As more
8
and more labour is used, at the given wage rate (say, a wage
rate given in the manufacturing sector in a situation of
surplus labour), the wage-bill increases linearly as shown by
OW. Given the total product curve 00 , output is maximised
when OL labour is used. The surplus available (assuming
that all wages are consumed) over the wage-bill is, however,
only TR = TL RL. On the other hand, surplus is maximised
by using OL labour, where a tangent to the total product
curve, 00, is parallel at point M to the wage line OW.
Following the Galenson-Leibenstein reinvestment criterion,
output at point M will be preferable to output at point T.
(Note that the maximum surplus depends on the wage rate
and need not necessarily go with the most capital-intensive
techniques.)
SOCIAL COST-BENEFIT METHODS
(based on shadow prices or accounting prices)
Two pioneering works:
1.
I M D Little and J Mirrlees (1968, Manual of Industrial

Project Analysis for Developing Countries (Volume
II) Social Cost-Benefit Analysis, OECD Development
Centre, Paris). Subsequently produced as a successor
volume by the authors, Project Appraisal and
Planning for Developing Countries, Heinemann
1974; and
2.
P Dasgupta, A Sen and S Marglin (1972, Guidelines

for Project Evaluation, UNIDO, UN).
The former has come to be known as The OECD Method

(and also the LM method, after its authors) and the latter as
The UNIDO Method.
THE CONCEPT OF SHADOW PRICING
These prices are not real in the sense that they do not
represent current prices of inputs and outputs, but they are
9
true indicators of the realities of economic scarcity of

these goods from the social point.
Such prices, invented for the purpose of social appraisal, are
called shadow prices or social accounting prices or
(confusingly) simply accounting prices.
As the existing prices fail to reflect adequately the social
opportunity costs of the various goods and resources, a
system of shadow prices needed to be developed that would
give the right relative values to the different items.
By using shadow prices, a project planner is avoiding bad
guesses and he/she is viewing the costs and benefits of the
project not from the point of view of commercial profitability
but social profitability.
COMPREHENSIVE SHADOW PRICING IS A SECOND
BEST
The OECD and UNIDO authors recognise the second best
character of the use of any set of shadow prices.
No claim is made, according to Little and Mirrlees (1974, p.
37) that accounting prices can be exact reflections of social
cost and benefits merely much better reflections than
actual prices for many projects in many countries. Nor, of
course, it is claimed that the use of accounting prices is a
very satisfactory method of dealing with distortions. Many of
the distortions can be fully dealt with only by removing
them, that is, by adopting policies which lead to proper
correspondence of prices, costs and benefits.
10
VALUATION OF GOODS
(See also Thirlwall (1999), pp. 254-57)
Tradables
According to the OECD method, all the items inputs and
outputs which can be traded are valued at Border
Prices.
Non-Tradables
(Items which are not normally traded internationally, e.g.
electricity and transport)
For minor items, a standard conversion factor equal to
the rate of the domestic price to international price may
be used.
But for major items it is necessary to breakdown the
different items of costs.
VALUATION OF FACTORS OF PRODUCTION
Land:
The valuation of land depends on its alternative uses,
subject to the use of shadow prices and correction of the
adverse effects of income distribution where land is privately
owned.
Labour: Distinction between skilled and unskilled labour:
See Thirlwall (1999), pp. 258-60.
Capital:
See Thirlwall (1999), pp. 257-58.
SOCIAL RATE OF RETURN (as distinguished from the
COMMERCIAL RATE OF RETURN)
Based on shadow prices.
11
DIFFICULTIES OF ADMINISTERING SHADOW OR

ACCOUNTING PRICES
Such prices need to be administered at the macrolevel.
A country may not have the organisational set-up
for this purpose.
Such prices need to be applied systematically
Such a systematic approach may be lacking in the
developing country concerned.
Because of shortage of administration, allocation of
resources through a set of alternative prices
(different from market prices) will be difficult to
carry out efficiently.
EVIDENCE FROM DEVELOPING COUNTRIES

See e.g. M M Huq (1989), The Economy of Ghana, pp 25866.
Neither of the conditions stated above was satisfied in Ghana
(as found by Huq, 1989, p. 261, during the early 1980s when
the Ghanaian economy was suffering from serious price
distortions).
As there were no central guidelines for the use of a set of
shadow prices, different investing agencies were using
different criteria in appraising projects in Ghana.
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Choice of Techniques in Production

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The choice of techniques is an area of economics in

which the question of the

The isoquant I represents the different methods of producing

Figure 2: Optimum Technical Choice in Developed and Less

Technological rigidity. The production function may not be

Input prices may fail to reflect relative factor availability.

Market prices of factors of production may not properly reflect

Labour-intensive techniques may require a great deal of

Labour-Saving Bias in imported technologies.

Dependence of foreign aid also often leads to the import of

NEED FOR IMPROVED ALLOCATION METHODS

The minimum capital-output ratio criterion, advocated by J J

The marginal per capita reinvestment quotient criterion,

THE MINIMISING CAPITAL-OUTPUT RATIO CRITERION

Figure 3: Minimising Capital-Intensity per Employee

It is apparent from Fig. 3 that a horizontal equal-cost curve, as

THE MARGINAL PER CAPITA REINVESTMENT QUOTIENT

The conflict between employment and saving has also been

I M D Little and J Mirrlees (1968, Manual of Industrial

P Dasgupta, A Sen and S Marglin (1972, Guidelines

The former has come to be known as The OECD Method

true indicators of the realities of economic scarcity of

DIFFICULTIES OF ADMINISTERING SHADOW OR

EVIDENCE FROM DEVELOPING COUNTRIES

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