Dynamic Effects o f Factor Policies

Divergences in factor prices take on heightened importance in a dynamic context because of influences on the pattern of technological change. Technological change tends to reduce dependence on scarce, relatively expensive resources. For producers, private market prices rather than social prices are the indicators of relative scarcity, and divergences can allow technological choices that increase income in private market terms but reduce it in social terms. Similar possibilities arise in considering technological transfers, in which production practices are imported from foreign countries that have relative factor scarcities very different from those of the recipient country. The important divergences in a dynamic context may be different from those that dominate static analyses. Capital market distortions, for example, are usually unimportant in the evaluation of labor-intensive agricultural systems. But such policies can assume major importance for the process of structural change and the future development and adoption of more capital-intensive production techniques.

Public investment decisions are also critical to the process of technological change. The public sector is left with much of the responsibility for creating and introducing many of the innovations and for making investments complementary to technical change, because many of these activities involve public goods. Roads to market inputs and outputs, infrastructure for water delivery and electricity, institutional support for the extension of the financial system to rural areas, and education (schooling and extension) are examples of services that benefit agriculture but are not adequately provided by the private sector. Domestic research and development of new technology are rarely undertaken by the private sector, unless the technological change is embodied in a single input not easily replicated (for example, improved hybrid seeds). To the extent that public investment decisions are influenced by private rather than social incentives, factor and commodity divergences again influence the pattern of technological change and growth.

Technological Change

Technological change allows the minimum costs of production to decline when factor prices are held constant. The impact of technological change is illustrated in Figure 4.6. Given only two available inputs, labor (L) and capital (K), the production isoquant Q_food shows the combinations of labor and capital inputs that can be used to produce one unit of food. To produce a given output, the producer considers the tradeoffs between additional capital input costs and increasing

labor costs. In the figure, movement along the production isoquant from point a to point b raises capital costs by (delta K x r) and lowers labor costs by (delta L x w). When the producer finds the point where further changes in input combinations no longer reduce total costs-that is, (delta K x r) = - (delta L x w), or delta K/delta L = -w/r-minimum costs of production are realized. The slope of the isoquant equals the negative of the relative price ratio. Point b represents this minimum-cost combination. Technological change occurs with the introduction of a new production isoquant, Q_food. Lesser amounts of both inputs are needed to produce a given level of output (K_b and L_b decline to K_c and L_c, respectively). The optimal input combination is represented by point c. Given a fixed supply of labor in the economy, the potential production of food increases. In Figure 4.66, the technological change causes an outward shift in the production possibilities curve, from EF to EF'. Output increases from point B to point C; in this illustration, the output of both commodities increases. The total income gain to the economy can be measured in terms of either good; when food is the numeraire, the gain is P_F(X - Y).

Analytical complications are introduced by the presence of divergences and by the possibility of input substitution. These complications are also illustrated in Figure 4.6a; if w and r represent the undistorted social prices of labor and capital, and if these factor prices are distorted by policy, so that labor becomes relatively more expensive and capital becomes relatively cheaper, the producer begins anew the search for the least-cost combination of inputs. Input substitution is practiced within the existing technology. Cheaper capital is substituted for more expensive labor, with the producer ending up at a point such as d. Relative to point b, labor input per unit of output has declined, just as in the technical change case. But the input of capital has increased. In aggregate terms, the economy shifts to an output point within the maximum production possibilities frontier (such as point D of Figure 4.6b) because the new technology provides an inefficient way to absorb total factor supplies.

The impact of factor distortions may be compounded over time as a result of the bias imparted to technical change. In the distorted situation, initial investment in research and complementary infrastructure begins with the firm and the economy located at points d and D in Figures 4.6a and 4.6b, respectively. If the investment is successful, the production isoquant will shift inward, at least with respect to point d. The production possibilities curve then shifts outward relative to point D. But unless the new production point shifts outside (northeast) of line YB, investment resources have been wasted; the investment was spent to move the economy to an income that could have been realized without any technological change (instead allowing producers to respond to social factor prices).

Further, the impacts of investment on the isoquant are not likely to be uniform; more likely the investment has greatest impact relative to the initial starting point and initial factor price incentives. An investment made at the factor prices corresponding to point d generates a new technology (and isoquant) that will look different from the isoquant portrayed as Q'_food in Figure 4.6a. Costs for capital-intensive techniques will have been reduced more than costs for labor-intensive techniques, and point C would not be on the new isoquant. In this circumstance, the production possibilities frontier will not reach surface ECF' in Figure 4.6b. The economy would have realized larger income growth by focusing investment on cost reductions for more labor-intensive techniques. Of course, non-efficiency objectives may be paramount to the investment decisions taken; the point here is that the efficiency costs of factor policy may well be larger than those suggested by partial equilibrium analyses of the type described above.

Dynamic Externalities

As industries mature and expand, they may generate new technologies or improved inputs that will benefit other industries. Such dynamic externality benefits, including improvements in labor skills and access to international markets, can arise from interactions across a wide range of industries. Alternatively, some particular subset of industries might be considered the prime generator of technical change and inter-industry externalities, mandating an unbalanced approach to economic growth. Factor market policies and public investments are likely to play a critical role in this process (although commodity price policies can also be important), because they encourage the development and use of particular types of capital and labor inputs.

In agriculture, inter-commodity externalities are relatively rare. Most technical changes are generated outside the production sector and are commodity-specific by necessity. Most dynamic externalities therefore arise from inter-industry effects. The infant industry argument is the most common example of this type of dynamic externality. Average costs are high relative to output price in the initial period. But over time, learning by doing causes costs to decline. Producers discover more efficient ways of operating, and labor productivity increases as workers develop better understanding of their jobs. In a future period, average cost is below the world price. The static perspective in the first period would judge the activity to be inefficient and socially unprofitable. In contrast, the dynamic perspective would see positive net benefits and a socially profitable activity. The short-run losses of the first period are a necessary consequence of the industry's operation, but the net present value of these losses plus the later gains could be positive.

In agriculture, the phenomenon of increased efficiency over time is commonly observed when a technology embodying new inputs is introduced. Farmers rarely know a priori the optimal amounts and timing of fertilizer application. But after several seasons of trial and error, physical relationships become better understood and efficient economic decisions can be made. Similar considerations apply to marketing and processing. How to operate new machinery, develop optimal methods of quality control, and tailor product specifications to the demands of particular consumer groups is rarely known perfectly in advance. For this reason, profitability estimates do not place much emphasis on initial experience.

Problems with the infant industry argument arise when gains in efficiency prove to be less dramatic than expected. Policies to support the adoption of fledgling technologies include direct producer subsidies, protection from imports (or subsidization of exports), and subsidization of inputs that embody the technology. But infant industry protection can create a situation of enduring positive private profitability (D > 0) and negative social profitability (H < 0). If efficiencies do not improve over time, the industry remains dependent on policy for its existence. Industry lobbyists then shift from infant industry arguments to other rationales in an attempt to maintain the support of policymakers for an inefficient activity.