Month: March 2010

Model Building and Planning in India

Ever since the First Five Year Plan, we have utilised models in order to channel resources for achieving objectives of higher growth, establishing strong capital base, strengthening import substitution, reducing poverty, increasing foreign exchange resources and so on. The early plans made use of Harrod-Domar model and the Feldman-Mahalanobis models. The models used for planning purposes were largely taken from economic theory, which were then adapted (hopefully) by the Planning Commission. Owing to changes in the structure of the Indian economy, the nature of modelling has also undergone various alterations. This post highlights certain issues in the macro-modelling that was done for the 11th Five Year Plan, chiefly based on the publication by the Planning Commission Macro-Modelling for the Eleventh Five Year Plan of India edited by Kirit S Parikh.

It is incorrect to argue that planning in India has become redundant after the 1991 reforms. These reforms provided freedom to the firms with respect to what to produce and how to produce them. As the recent global financial crisis has shown, unregulated finance can lead to unfavourable outcomes for the financial as well as the real sectors of the economy. Also, significant divergences in income and wealth are being reported. This is the case, especially in India which is home to some of the richest and poorest people in the world. As Parikh writes, ‘As long as disparities in income, endowments and wealth persist, access to public goods and services is uneven and infrastructure paucity is there, we need active government policy. We need planning.’ [Planning Commission 2009, 16]

The 11th Five Year Plan’s goal is to have ‘Faster and More Inclusive Growth’. The basis of this goal is that the growth of GDP is treated as a necessary and almost sufficient condition for improving livelihoods. We know that markets exclude those without adequate purchasing power. And growth in GDP mainly results in an increase in the extent/size of the market. Unless appropriate systems are in place, ‘trickle down’ does not take place. Hence, an outline of how ‘inclusive growth’ can take place needs much greater attention. And it is disappointing to see that employment generation is not considered as a central objective. For the first time, the inputs of the 11th Five Year Plan have been provided by a ‘modelling forum’. The forum consists of researchers from NCAER, IGIDR, IEG and ISI Bangalore apart from the in-house team of the Planning Commission.

A formal model is constructed for the purposes of planning because it makes the assumptions transparent, ensures consistency and provides insights into the inter-relationship between various actors and sectors in the economy. These models in turn borrow concepts, categories, functional relationships and links from the paradigms in economics. The paradigms that have influenced modellers, according to Parikh are Input-Output, Walrasian, Neoclassical, Keynesian, Structuralist, Vector Auto Regression/Error Correction, New Neoclassical and Dynamic Stochastic General Equilibrium. The most obvious drawback of this classification is the mix-up of paradigms with tools of economics. For instance, IO framework, VAR models and DSGE models are only tools. For our later exposition, it would be helpful to point out the important characteristics of each of these paradigms/tools.

Input-Output: Usage of inputs in fixed proportion

Walrasian: Optimising behaviour of economic agents

Neoclassical: Pricing through supply and demand mechanism and full employment at prevailing wage rate

Keynesian: Underemployment equilibrium

Structuralist: Imperfect markets and incomplete monetization of the economy

Vector Auto Regression: All variables depend on lagged values of all variables and data speak for themselves

New Neoclassical: Microeconomic foundation of macroeconomics- importance of information, expectations and contracts

DSGE: Forward looking and optimising economic agents

In the modelling for the 11th Five Year Plan, six different models with different analytical approaches have been used. The models are a) Perspective Planning Division’s In-house Model, b) A VAR/VEC Model from ISI, Bangalore, c) A General Equilibrium Model from IGIDR, d) An Econometric Model from IEG and e) Macro-Econometric Model of NCAER. The various model scenarios show that the direction of policy shocks are similar ‘though the structure and philosophy of the models are different’. However, this is not such a shocking or an interesting revelation. For everybody knows that oil price shocks have a negative impact on the GDP growth rate and that the global slowdown affects the GDP adversely. The only result of interest is that of an increase in NREGs by 1% of GDP. This will result in an increase of around 0.35 to 0.5 GDP percentage points. However, it must be noted that this is based on ‘a general equilibrium model in which it is assumed that the adjustments to the new equilibrium are completed in one year. Thus, the impacts may be overstated as in reality this may not be the case’.

Overall, it seems that the assumptions of the various models are far from our Indian reality. There is no attempt at including the unorganised sector. And it is very clear, from the recent evidences from neuroeconomics, experimental economics and game theory that individuals are not rational optimizing machines. Instead, we are more moved by social concerns and we exhibit a pro-social behaviour which is norm-based. There is no explicit move to analyse employment generation. Nor is there the necessary focus on agriculture. It is stated that agriculture needs to grow by 2.4 % to 4 % so as to achieve 9% GDP growth rate. One cannot help but wonder whether the objective of economic planning in India is only about the GDP growth rate! And as to the use of VAR models, the generators of the model argue that since there is ‘no real basis to say which variable is endogenous and which is exogenous’, they adopt a ‘general equilibrium approach, where everything (except rainfall, of course) depends on everything else.’ [Planning Commission 2009, 88] An easy route indeed!

This publication by the Planning Commission is a must read for all those who are interested in understanding the Indian policy making. Also, it provides the crucial link between policy and theory. Hence, making the study of economic theory very significant, especially for policy makers. It will also be of interest to students and practitioners of time series methods using the VAR framework.

Reference

Planning Commission (2009), Macro-Modelling for the Eleventh Five Year Plan of India, edited by Kirit S Parikh, Academic Foundation: New Delhi.

Knut Wicksell: Some Aspects of his Work

This post is different from the others because it deals with the contributions of a single economist. Knut Wicksell was a Swedish economist who made significant contributions to capital theory, monetary economics and fiscal policy. Despite being grouped under the neoclassical or the Austrian school because of his affinities to ‘marginal’ analyst, Wicksell was a socialist and a radical. He advocated policies which involved the government in a big way. And owing to his varied interests in poetry, mathematics, feminism, mathematics, politics, etc he became a Professor of Economics and Fiscal Law at Lund University only when he was fifty. A few of his well known students are Erik Lindahl, Gunnar Myrdal and Bertil Ohlin. They are considered to be part of Stockholm or Swedish school of economic thought.

In the passages below, only a few of his contributions will be elaborated. He has also made lasting contributions to the theory of interest, revitalised quantity theory of money, introduced mechanisms linking the real and monetary sector, etc.

Wicksell demonstrated that problems could arise if capital is treated just like other ‘factors of production’ ‘ land and labour. Cambridge capital controversies dealt with many of these problems. ‘Knut Wicksell (1851’1926) himself casts doubt on the specification of the value of capital, along with the physical quantities of labour and land, as part of the data of the system. ‘Capital’ is but a set of heterogeneous capital goods. Therefore, unlike labour and land, which ‘are measured each in terms of its own technical unit . . . capital . . . is reckoned . . . as a sum of exchange value’ (Wicksell, 1901, 1934, p. 49). But capital goods are themselves produced commodities and, as such, their ‘costs of production include capital and interest’; thus, ‘to derive the value of capital goods from their own cost of production or reproduction’ would imply ‘arguing in a circle’ (ibid., p. 149).’ [Segura and Braun 2004]

Like other contemporaries of his, Wicksell did not write about unemployment. This was because the existence of unemployment was considered to be a paradox, an anomaly for neoclassical economists. As they could not comprehend why resources (here, labour) would be left idle! The central problem in (neoclassical) economics was not to provide or create uses for factors, but only to allocate the factors among various uses. As Bo Sandelin, editor of Wicksell’s papers and the author of A History of Swedish Economic Thought writes in the introduction that ‘the fundamental question in economics was how to manage an economy with scarce resources.’ Strange indeed!

Wicksell was a strong proponent of the marginal productivity theory of distribution. A corollary of this theory is the the sum of all the marginal products of the factors should be equal to the total product, known as the product exhaustion theorem. However Wicksell demonstrated that the operation of this theory depends on the returns to the scale. That is, only under constant returns to scale will the marginal products exactly add up to the total product. And that for both decreasing returns and increasing returns, the product will not be completely exhausted.

The Swedish school made another important contribution to economic theory. They introduced the categories of ex ante and ex post. These categories, we know are used widely today and were the result of the School’s dissatisfaction with the equilibrium analysis. Apart from these ways of thinking, Myrdal has provided us with the concept of circular and cumulative causation as well. These categories provide us with alternative modes of conceptualising or thinking about economic problems.

Relying solely on textbooks reduces our extent of reach. We often fail to come across interesting and heterodox economists. But, history of economic thought provides us with ample personalities to look into. Wicksell is one among them. Also, some of their categories provide us with alternatives, which remain unfinished. For instance, after going through some of the secondary and primary works on/by Wicksell, he appears exceedingly interesting and aware of the implications of certain simplifying assumptions. He pointed out the ‘necessity’ of the constant returns to scale assumption, which economics faithfully aligned with for a considerable period. This was challenged within the mainstream only with the entry of the endogenous growth theories, which emphasised increasing returns.

References

Pressman, Steven (2004), Fifty Great Economists, Routledge: India.

Groenewegen, P and Vaggi, G (2006), A Concise History of Economic Thought: From Mercantilism to Monetarism, Palgrave Macmillan.

De Marchi, N and Blaug, M (1991), Appraising Economic Theories: Studies in the Methodology of Scientific Research Programmes, Edward Elgar.

Segura, J and Braun, C (2004), An Eponymous Dictionary of Economics: A Guide to Laws and Theorems Named After Economists, Edward Elgar.

Sraffa: Production as a Circular Process

This is the second in the series of posts on Sraffa. The objective of this post is to clarify the assumption of scarce resources made frequently in neoclassical economics. This is then contrasted with the notion of mass-production in capitalist economies. This facet of capitalism is understood by concepts such as ‘circular production’ and ‘production of commodities by means of commodities’ in Classical Economics.

A brief look at the history of micro and macroeconomics becomes essential. Elements of Marshall and Walras are found in modern microeconomics. Specifically, partial equilibrium analysis comes from Marshall; whereas, Walras contributed ‘general equilibrium analysis’ to economics. Usually, emergence of macroeconomics is considered to have originated with the work of Keynes. This has been contested and it has been shown with considerable evidence that William Petty (1623-1687) was the first macroeconomist. [See Murphy 2009] And that economists like Adam Smith, David Ricardo and Karl Marx were talking about macroeconomics when they discussed production, distribution and accumulation. Neoclassical macroeconomics can be loosely said to comprise New Classical Economics, Neo-Keynesian Economics, variants of Computable General Equilibrium Models (CGE), etc. One of the unifying features of the above mentioned neoclassical schools/models is the assumption of ‘scarce factors’. It is owing to the assumption that factors are scare, that optimization is carried out.

Lionel Robbins defined economics as ‘the science which studies human behaviour as the relationship between ends and scarce means which have alternative uses.’ Here, scarce means refers to scarce factors of production ‘ land, labour and capital. Yes, land can be considered scarce in an economy where the pressure of population is high (or for environmental reasons). But, wouldn’t labour be scarce in some countries and abundant in others’ Now for the tricky ‘capital’. Capital is understood as produced means of production. That is, tools, machinery, plants, conveyor belts, electrical appliances, tractors, etc are ‘capital goods’. Are they scarce’ They would be scarce if nobody produced them. Usually, in a capitalist or quasi-capitalist economy, capital goods are produced by the private sector, the government and often, imported from abroad. Therefore, a priori, we have no reason to maintain that capital is a scarce factor. Or for that matter, even labour.

Marshall provided a theoretical partition through which one could say that factors are scarce. He introduced the concept of ‘short period analysis’. Till Marshall, the early classicals and neoclassicals analysed economies using the ‘long period method’. Through the short period, Marshall introduced an imaginary period wherein one factor is fixed (usually, capital) and the other factor (labour) is variable. In this period, it is as if one factor is scarce. In a later post, it will be shown that this sort of analysis is an improper generalisation of Ricardo’s theory of rent.

Sraffa’s Production of Commodities by Means of Commodities deals with ‘value and distribution’. That is, he focuses on the relationship between relative prices, wages/profits and technique of production. Throughout the whole analysis, output/quantity is treated as given. This is in tune with the ‘sequential analysis’ of classical economics. Value & distribution is one level of analysis or the ‘core’, as was popularised by Garegnani. Once, the foundation is well-established, the next level is growth & accumulation. In the first level, quantities are treated as given and in the second level, prices are assumed to be given. This is done keeping in view the complexity of the economic processes. Whereas, as we know, in neoclassical theory of general equilibrium, there is a simultaneous determination of quantity, price, wage rate, employment, rate of interest and quantity of capital. That is, all kinds of prices and quantities are simultaneously determined.

A set of equations from classical and neoclassical production theory is given below. This is so as to bring out the differences in a clear way.

Production function: Ya = f(La, Ka)

Sraffa’s equations:
(AaPa + BaPb + … + KaPk) (1 + r) + LaW = APa
(AbPa + BbPb + … + KbPk) (1 + r) + LbW = BPb
. . . . . .
(AkPa + BkPb + … + KkPk) (1 + r) + LkW = KPk

where A, B …. K are the output produced in various industries, L is the labour employed in each industry, Pa refers to price/value of output A and Pk refers to value of output K, r is the rate of profit. [As these are for purposes of illustration alone, some conditions have not been mentioned]

In the first case, it represents the transformation of inputs ‘ labour and capital into an output Y. Let me reproduce what Sraffa writes about his particular conception of production: ‘It is of course in Quesnay’s Tableau Economique that is found the original picture of the system of production and consumption as a circular process, and it stands in striking contrast to the view presented by modern theory, of a one-way avenue that leads for ‘Factors of production’ to ‘Consumption goods’.’ [Sraffa 1960, 93]

The concept of circular production also brings to the fore the web of connections between different production structures. Both classical and neoclassical economics attempts at reducing the complexity of economic phenomena. Neoclassical economics, at the outset abstracts away from interrelated production structures through the concept of ‘representative firm’ in microeconomics. In a similar way, in the area of consumption, man as a social being is reduced to man as an individual whose utility does not depend on that of others. Classical economics carries out its analysis by taking prices as given so as to analyse interrelated production structures.

References

Sraffa, P (1960), Production of Commodities by Means of Commodities, Cambridge: Cambridge University Press.

Murphy, A (2009), The Genesis of Macroeconomics: New Ideas from Sir William Petty to Henry Thornton, New York: Oxford University Press.