Caption title"October 1960."At head of title: Econ. Dev. Program, INDIA PROJECT"L2-1210"--handwritten on p. [1]Includes bibliographical reference

Sen, Amartya, 1933-

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Econ. Dev. ProgramINDIA PROJECT-C/6o-13October 1960.SOME ASPECTS OF CAPITAL AND ECONOMIC EFFICIENCYA. K. SenIn this note we try to explore certain aspects of the concept ofproductive capital, and some of their implications on the problems ofeconomic efficiency. In the first section the concept is examinedand some of its practical implications are pointed out. In thesecond, a special aspect of the problem, viz., working capitalrequirement for household-based economic operations, is discussedin the context of agriculture in the underdeveloped economies. Inthe final section, the concept of economic efficiency as affected bythe nature of productive capital is studied.IThe factors of production, as we are told in any textbook, belongto three groups: land, labour, and capital.I (Alfred Marshall'ssomewhat dubious "organization" seems to have been quietly dropped inrecent years.) What is included in the last category is not always1. P. A. Samuelson, Economics, An Introductory Analysis (New York,1958), p. 575.04-2-quite clear. It is not unpopular to identify capital with capitalgoods, even with just machinery, and this view is reflected in themeasurement of the degree of capital intensity in terms of per capitaavailability of "horsepower,"2 or of "tons of steel."3 If, however,capital stands only for machinery, then the three-fold classificationof factors of production into land, labour, and capital, is obviouslyincomplete. What about raw materials, and intermediate goods, otherthan machinery. The horsepower-steel view is, of course, not the onlyone used in this level of analysis, and another quite common definitionof capital seems to be "all man-made productive assets, from buildingsand machinery to materials and fuel."h But, then, what about labourin the pipeline of production? If there is a time-lag between theapplication of operating labour and the consequent output flow, someamount of labour will be locked up in the production process, forminga part of the working capital. One can avoid this problem by treating"semi-finished goods" as constituting another factor of production andincluding the value of labour in the pipeline in the price of thesesemi-finished goods. But treating semi-finished goods as factors ofproduction, does not go very happily with the usual concepts of factorsof production, Of course, one can say that labour in the pipeline canbe put under "labour" of the trinity of land-labour-capital, but there2. L. Rostas, Comparative Productivity in British and AmericanIndustry (Cambridge, 194*8), p. 51.3. N. Kaldor, "A Model of Economic Growth," Economic Journal,December 1957, p. 592.h. F. Benham, Economics (London, 1955), p. 101.-3-.is no doubt that in one sense, the value of the working capital(including labour in the pipe-line) is a part of the capital.The whole problem, it seens to me, arises because we seem to usethe term capital in two completely different senses. In the three-foldclassification of factors of production, "capital" covers all man-mademeans of production, thereby providing a residuary category for allagents of production other than those provided by nature, and otherthan human labour. When, however, we refer to "capital" in the contextof investment, or in the context of the stock of value that is to bemaintained in a production unit, we are referring to quite a differentthing. In this sense, "capital" is best looked at as a stock of factorsof production that must be maintained to keep production going. Thestock of labour, of materials, of machines, etc., that the entrepreneurhas paid for and has not yet received full return from, make up thiscategory. If we are using capital in this sense, we do not treat itat par with labour and land, and we must use a more specific term, e.g.,capital goods, for the residuary category of factors of productionreferred to above.Why, we could be asked, are we being so particular about thesedistinctions? The answer is that the concept of capital as a particularfactor of production comparable with land and labour has been responsiblefor considerable confusion of thought and policy, since the term capitalis also used in the other sense. The confusion between capital as anecessary stock and capital as a type of productive factors, leads on theo ne hand to theories that make the expansion of the productive capacityof an econory dependent entirely on the production of capital goods5,and on the other, to a concept of investment that concentrates onmachinery and not on other things, e.g., a surplus of consumer goodsfor the labour in the working capital, necessary for a successfulexpansion of productive capacity. For example, we find that the IndianPlanning Commission defines investment as "expenditure on certainphysical assets (e.g., buildings and plants and equipment), includingexpenditure on personnel required for putting up these assets."6 Thisunderestimates the investment requirement of Indian Plans fairlyconsiderably. A rough estimate that the present writer tried to makefrom the available Indian statistical information indicated that theadditional working capital requirement tended to be more than a quarterof the net fixed investment in India.7 The reason why this investment,which is undertaken, can escape being counted in the investment statistics,is not merely that there is a confusion about what capital means, butalso that this capital formation is financed largely by borrowing fromshort-run sources of finance, which, of course, does not affect the fact5. Even Mr. N. Kaldor seems to define "the value of the stock ofcapital" as "the values of the capital goods produced in the past" "lessaccrued depreciation." ("A Model of Economic Growth," Economic Journal,December 1957, pp. 598-9.)6. Third Five Year Plan - A Draft Outline (New Delhi, 1960), p. 25.7. In this unpublished paper the sectoral ratios of additional workingcapital to additional net income were taken to be 0.90 for mining andmanufacture, 1.50 for small industries and construction, 1.17 for tradeand commerce, 0.06 for agriculture, and 0.11 for railways and communication.The weighted average ratio of working capital to net fixed investment workedout as 27 per cent. In the Third Plan Draft, rather contrary to their owndefinition there is some provision for "inventories" in investment withoutelaboration of what it contains (p. 26). The ratio of this "inventories"to net fixed investment, however, seems to be only 8.5 per cent, as opposedto our over-all working capital requirement ratio of 27 per cent.-4--5-~that they do demand a surplus of real income over real consumption inthe same way as any other type of investment does.A second result of ignoring the working capital, and one that inthe opinion of the present writer is very important, is the lack of anyorganised attempt to save the requirements of working capital. One cannotconsciously save something that one does not know one uses, and this canbe quite serious in economies suffering from capital shortage. Thepossibility of saving working capital depends on the extent to which thevarious time lags between current inputs and current outputs can bereduced, not merely (a) within particular industries, but (b) in theprocess of transfer from one industry to another. Not much work has goneinto this problem, which probably indicates the extent to which thisaspect of investment policy has been inadequately appreciated. Polandseems to provide one of the few exceptions to this rule, and it is claimedby Professor Wlodsimierz Brus that in the Polish econonr the share ofnet fixed investment in the national income will be considerably raisedbetween 1958 and 1965 with a constant share of total investment in thenational income, this being achieved by a reduction in the ratio ofadditional working capital to total investment from more than a third in1958 to less than a fourth in 1965.8 If this is, in fact, achieved, itwill indicate that the cost of ignoring the economics of working capitalmay be very considerable for a developing econor.8, Zycie Gospodarcre, January 11, 1959.IIOne special aspect of working capital in underdeveloped economiesdeserves attention. In a very big part of most underdeveloped economies,the household provides the basis for economic operations, and wage labouris relatively rare. This means that the remuneration to labour, in thissector, need not increase with additional labour until the fruits ofthat labour are reaped, so that the working capital requirement in termsof consumer goods fund is to that extent reduced. Take the case offertilizers being supplied to a group of peasants cultivating land on afamily basis. The additional labour they will now put in along withfertilisers will receive no additional remuneration until the additionalproducts resulting from this are reaped. If, on the other hand, a wage-based farm employed additional labour to apply fertilisers, the wage-billwould have gone up immediately, and the existence of unemployed labourwould not have prevented the requirement of a surplus stock of consumergoods for the employment of additional labour. This means that thehousehold economy achieves a certain saving of working capital that isnot possible for the wage-based econonr, and since the process of develop-ment is also partly a process of conversion of the household-based9. In so far as some additional saving is now done by (a) those whowere supporting the unemployed people before they found new employment,and/or (b) by the newly employed people themselves, the requirement of thesurplus stock will be smaller. The prospects of this providing muchvoluntary savings is not, however, very great in a poor economy, so thatsome taxes will be required if a substantial part of the additional workingcapital requirement is to be met by additional savings from these sources.There might, however, be some voluntary shift in the commodity pattern ofconsumption which might, to some extent, ease the process of capitalaccumulation through a change in the relative prices. For a discussionof this problem, see "Unemployment, Relative Prices, and the Savings Potential,"by the present writer, Indian Economic Review, August 1957.-7-economies into wage-based ones, the requirement of working capital islikely to grow, to that extent, more than proportionately to income.This makes the necessity of discussing this aspect of capital all themore important.We must, in this context, examine the view of Professor C. P.Kindleberger about the relative decline of the requirement of capitalrepresented in "inventories" with the growth of an economgr, resultingfrom a fall in the ratio of agricultural output to total output. Hesays (in his chapter on "Capital"), "since agricultural output is producedat one time of the year and consumed evenly over the year as a whole,half of output on the average is in inventories at a given time. Thisis a higher ratio than industry or services. In consequence, since theproportion of agricultural output in total output declines as income grows,the ratio of inventories to output declines." 10 Now, this argument iscertainly valid in so far as "inventory" is defined as any stock of goods,but it does not tell us much about "inventory" viewed as capital necessaryfor production. The crucial difference between a wage and a non-wageecononr is relevant here. In a non-wage economy this stock is in thenature of purely a consumption stock without representing a necessity forproduction, at the margin. The size of this stock does not have to beincreased prior t expanding production through the employment of morelabour; on the contrary, the expansion of this stock is only a result ofa larger rise of output.One should emphasize, in this connection, the distinction betweenstocks arising due (a) to the temporal discontinuity (or the seasonal10. Economic Development (New York, 1958), p. 38,nature) of output in agriculture, and (b) the working capital that maybe needed due to the time ag between input and output in this sector.The former does not demand arr productive investment. Think of anecononr where agriculture is permitted only on January 1, i.e., theoutput is extremely seasonal, but the seeds sown in the morning areharvested in the afternoon of January 1, out of which the workers arepaid, i.e., the time lag is negligible. There is no need here for arrworking capital for labour in the pipe-line, and more labour can beemployed without the necessity of the prior presence of an additionalstock of wage goods. The stock of output will be gradually spent betweenone January 1 and another, but this need not be expanded to employ morepeople on arr January 1. So this does not serve as working capitalnecessary for expansion.The effects of a time lag between the application of labour and thearrival of the fruits of that labour are, however, quite different. Inagriculture this lag is long, and in one of the Ricardian models of agri-cultural production, working capital arising from this constitutes thewhole of agricultural investment. 1 As we have already mentioned, however,in underdeveloped economies with family-based, non-wage cultivation, thistype of working capital is not necessary from the point of view ofapplication of incremental labour. The underemployed peasant can worka little harder to apply, say, fertilizers, or water from irrigational11. This provides the basis for the Ricardian position, in contra-distinction to Robert Malthus, that the profit rate in agriculturedetermines the profit rate for the whole econovqr, since it is independentof the relative prices; the output, input, and capital for agriculturebeing all made of corn. (Essay on the Influence of a Low Price of Corn onthe Profits of Stock- 1815.)-. 9-mprojects, and they receive their return only when the additional outputis harvested.12 With the growth of an economy, there are, therefore,two different trends. As a result of a fall in the share of agriculturaloutput, the ratio of "inventories" to output may well fall in theKindlebergerian manner. But this will not imply a relative fall in theinvestment requirement under this heading. In fact, the decline of family..based production will tend to lead, other things being equal, to a largerrequirement of working capital. This prospect of working capital risingmore than proportionately to output poses interesting problems for planning,which development authorities must take into account.IWe now move on to the concept of economic efficiency in so far as iti s affected by the existence of capital. Since capital is not just onetype of factor input, but a stock of inputs that must be maintained for theproduction flow to take place, we cannot get a concept of economicefficiency based only on the maximisation of the ratio of output to input.Unfortunately, however, the idea that capital is just one type of inputhas led to a fairly widespread presumption that economic efficiency isprecisely this type of output-input-ratio maximisation. Professor P.Sargent Florence writes1 3  "...by efficiency I refer to a relation between120 However, in so far as harder work requires more consumption offood, there will be a certain requirement of incremental working capital inthe shape of a stock of food.13. The Logic of British and American Industry (London, 1955), p. 49.Ar suggestion that costs should include an interest flow on the capitalstock is excluded by the definition of cost as "input."-10-return (or output) and cost (or input). Efficiency is indicated by theamount of return obtained at any given cost...." Similarly, in a recentcontribution to the concept of economic efficiency Lady Hall and Mr. C. B.Winsten write4, "As an example, to introduce the main ideas, suppose weare comparing mines, each with a similar labour force producing the samesort of coal with the sanw type and quantities of equipment, Then at thes i mplest level of efficiency ana3ysis we can suppose that we areconcerned with deciding where to produce coal, at mine A or at mine B.The answer would be, other things being equal, at the mine producing morecoal." More coal per unit of time, or more coal over the life of themines and equipment? Clearly efficiency is not mecessarily greater fora mine if it gives more coal in one sens44 and not in the other. To quoteanother example, Mr. N. H. Leyland defines efficiency as "the ratio ofuseful output to total input." "If one country or firm uses less of allthe factors of production than another to produce a given output, thenit is more efficient." Here again maximizing the ratio of output toinput provides the concept of efficiency, with no reference to the stocksof these factors that need be maintained. It could be argued that we arequarrelling about a definition, and any one has the right to define a termin whatever way one likes. In fact, however, the term "efficiency" hascertain accepted implications, and the question is a real one disguised ina definitional form. This is clear, for example, from Mr. Leyland's state-114. "The Ambiguous Notion of Efficiency," Economic Journal, March 1959,p. 70. It should be noted that the ambiguity referred to in the title isnot the one we are discussing.15. The British Econor 1945-50, edited by G. D. N, Worswick and P. H.Ady (Oxford, 1952), pp. 383-3864-11-ment that "efficiency is always desirable."16The best way of viewing the process is to imagine a continuous flow ofproduction with regular flows of inputs of different types with differentreplacement patterns. A particular machine might flow in once in ten years,that being its life; raw materials, on the other hand, require replacementevery time a new unit is produced; same with labour. There is an essentialsimilarity between these flows, but the time lags between these differenttypes of inputs and the outputs corresponding to them are different, anddepending on these, different quantities of these inputs are in the pipeline.If the average lag between the application of labour and raw materials isone month, then one month's labour and raw materials are in the pipeline.Depending on the life of the machinery, the quantities of machinery in thepipeline at different points of time can be found out, and from this theaverage value of the machines in the pipeline can also be calculated.Now, let us assume that an organizational, or technical, change reducesthe length (so to say) of the pipeline, keeping the input-output ratioconstant. Say, double-shift working is introduced as a result of whichoutput per machine per day is doubled, but the life of the machines ishalved. So the ratio of outputs to machine-inputs remain the same, butthe average value (per unit of output flow per day) of machines kept instock at any point of time goes down, thereby achieving an econor thatthe standard measures of economic efficiency, quoted above, fail to note,The same thing can happen with a reduction in the lag between raw materialinputs (or labour) and output, resulting in increased economic efficiency16. Op. cit., p. 383, I should mention that the object of quotingthese authors in particular is not to suggest that they hold a particularview not shared by others. On the contrary, the view is sufficientlywidespread to be confirmed by these random selections.-12-without being noted by the standard efficiency detector,The preoccupation of efficiency analysis with input requirement ratiosirrespective of the sE of economic operations, reveals that the mis-understanding of the nature of capital can have more serious practicalconsequences than is obvious at the first sight.

Some aspects of capital and economic efficiency

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Some aspects of capital and economic efficiency

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