Social Returns to investment and Rate of Return to Capital

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1 Social Returns to investment and Rate of Return to Capital October 27 th, 2010 Leonardo Garrido, PRMED

2 Social Returns to Investments in G.D. G.D. overarching question what is constraining private investment and entrepreneurship Is low private investments the result from lack of profitable business opportunities? From low social returns to economic activity or low appropriability of those returns? Formally, HRV introduce the rate of return (r) as being endogenous in the model, which depends on the country s productivity level (a) and the availability of complementary factors (x) HRV do not present a comprehensive explanation of the causes of low social returns But they highlight low returns problems that arise from the lack of some complementary factors or inputs, including infrastructure, geography and human capital, that cannot be provided by individual investors

3 Social Returns in G.D. Business Environment analysis Returns to economic activity Cost of finance Social returns Private appropriability International sources of finance Local sources of finance Poor geography Human Capital Bad Infrastructure Macro risks Government failures Micro risks Information externalities Market failures Coordination externalities Domestic savings Financial sector intermediation

4 Social Returns to Investments Geography Natural endowments (commodities, energy, land, water), connectivity (land-locked, access to thriving market), touristic potential, agriculture potential Infrastructure Roads, electricity, telecommunications, rail roads, air transport. Human Capital Knowledge and skills for advantage of available resources and dynamics of population and labor force Normally proxy-ed by education and health related variables (Jesus Crespo Cuaresma s presentation)

5 Assessing social returns What the analysis of social returns is about? Relative, not absolute returns Both, demand and supply factors that affect returns Market power and the possibility of extracting rents or extraordinary benefits from the economy Looking at aggregate and also at sectors It follows that, for assessing social returns it is convenient to break down the analysis of both supply and demand side issues. Supply side: Traditional areas of infrastructure, geography and human capital. Demand: Market opportunities for country s products. Also, we look at productivity

6 Productivity TFP: But: Does TFP s behavior adequately represents the overall productivity trends in the economy? Or is productivity thusly obtained mostly masked by a series of errors in parameter definition, data errors and model specification? Look at several other indicators and proxies for productivity: Cross country competitiveness indicators i.e. World Economic Forum Competitiveness Indicators Remember HRV criticism to these type of indexes Unit labor costs REER Escribano-Guasch Methodology based on ICS.

7 Caveat: Competitiveness is not Productivity They are not different words for the same concept Even so, we acknowledge the strong linkages between them As posed by Porter and Ketels (2003): Competitiveness remains a concept that is not well understood, despite widespread acceptance of its importance. To understand competitiveness, the starting point must be the sources of a nation s prosperity. A nation s standard of living is determined by the productivity of its economy, which is measured by the value of its goods and services produced per unit of the nation s human, capital and natural resources. Productivity depends both on the value of a nation s products and services, measured by the prices they can command in open markets, and the efficiency with which they can be produced. True competitiveness, then, is measured by productivity. Productivity allows a nation to support high wages, a strong currency and attractive returns to capital; and with them, a high standard of living

8 Rate of Return on Capital RoRK is important for applied growth economic work: It measures the contribution of investment to economic growth (Solow, 1956) and provides a basis for assessing the contribution of capital investment to the growth process RoRK is a key guide for estimating the opportunity cost of capital RoR K (ρt) is the ratio of the value of national income accrued to capital (Y k ) to the value of the national capital sock (K t ) ρ t = Y k /K t

9 Income Accruing to Capital Total Capital Income= (National Income - Total Labor Income ) Total Labor Income = (Total Wages & Salaries + Imputed Wages & Salaries) Imputed Wages & Salaries: A fraction of average income generated by a typical employee in each sector to account for proprietors, partners, self-employed, and unpaid family members

10 Estimation procedure: Problems Data in National Accounts are usually not in directly applicable form! The marginal productivity of labor in the public sector may differ from wages and salaries paid National accounts frequently identify employee compensation with income from labor, which implies that the income of unincorporated enterprises is entirely attributed to capital

11 Earnings directly attributable to capital Income accruing to capital Share of national income accruing to capital Capital Stock: Perpetual Inventory Method (Growth Accounting)

12 The rate of return to capital Make use of estimated capital stock and national income accruing to capital Hands on exercise

1 National Income and Product Accounts

Espen Henriksen econ249 UCSB 1 National Income and Product Accounts 11 Gross Domestic Product (GDP) Can be measured in three different but equivalent ways: 1 Production Approach 2 Expenditure Approach