Capital, Social Overhead

BIBLIOGRAPHY

The concept of “social overhead capital” (SOC) is used to identify the source of certain “basic” services required in the production of virtually all commodities. In its most narrow sense the term refers to transportation, communication, and power facilities. Such forms of capital as railroads, ports and harbors, hydroelectric plants, and telephone lines are always included in the SOC category. In broader but less common usage, facilities for such things as education and health, for maintenance of law and order, and for research are included. The discussion here is concerned only with the narrower concept.

The terms “economic overhead facilities” and “economic infrastructure” are frequently used as synonyms for SOC. The services supplied by such facilities are called “basic” to industrial activity because their use is generally required for production independently of the nature of the output of the industry. SOC may be contrasted with “directly productive capital.” The latter term refers to physical capital in the form of plant and equipment designed to produce a given product. The directly productive capital is used for the production of those products that add directly to final output, while SOC is assumed necessary to provide the service that makes possible the operation of all forms of directly productive capital. Another category of capital that is usually isolated for separate treatment is inventories and goods in process.

Characteristics. There are several characteristics of SOC that distinguish it from other capital (plant and equipment and inventories) and that warrant its isolation for special analysis:

(a) The services supplied by SOC are so widely used and their effectiveness is so dependent on what takes place in other sectors of the economy that the full contribution to the economy of such facilities is difficult to identify and even more difficult to measure. Thus, SOC is said to generate external economies [seeExternal economies and diseconomies] in that its existence results in reduced input costs to other sectors and the rewards arising from these reduced costs can rarely be captured by the enterprise originating them.

(b) The capital involved does not lend itself to very much divisibility, and the initial outlays to create SOC are often large relative to other forms of capital and relative to the total quantity of resources available to the economy for investment. Entry into the field is therefore difficult, and marginal costs are usually constant or declining over a wide range of output levels.

(c) An economy’s SOC facilities (in the narrow sense) are usually either owned outright by the government or their construction and operation are closely regulated by the government. The reasons for this are implicit in the two characteristics just noted. External economies, large initial outlays and technical indivisibilities, the difficulty of entry, and the likelihood of declining costs over a wide range all mean that the conventional competitive market mechanism does not produce acceptable results. Hence, government ownership or regulation is accepted as necessary. In a more general sense, SOC is often said to be in the public interest. This vague term is used to mean that, independent of specific costs and input considerations, the existence of SOC is thought to contribute to the achievement of an economic climate and environment that encourages and facilitates the development of the economy as a whole. The argument then is simply that as SOC is in the public interest, it should be controlled by public authority.

(d) Very few of the services provided by SOC can be imported. This characteristic follows from the very nature of the service—transportation, power, etc. The consequence of this is the important one that an economy does not have the option of importing these services and must allocate domestic resources to their construction and operation no matter what the productivity of these resources is in this type of activity.

Quantitative significance. Since about 1950 interest in SOC has centered almost exclusively on its role in economic development and in development planning in the low-income countries of the world. [SeePlanning, economic.] That this role is widely considered to be extremely important is evidenced by the proportion of available investible resources allocated to the creation of SOC in most development plans. For example, during the 1950s India allocated about 40 per cent of her total public investment to the building of transportation, communication, and power facilities. For Ghana the allocation for the same time period was 41 per cent, for Mexico 38 per cent, for Thailand 51 per cent, Ecuador 49 per cent, the Philippines 40 per cent, and Colombia 74 per cent. Percentages for other developing countries are similar.

Although the collection of data on capital formation always involves many rather arbitrary decisions, and the classification into transportation, communication, and energy may not be exactly comparable among all the countries, the percentages do show quite unambiguously that most governments are heavily committed to this form of investment. Since public investment usually amounts to at least one-half of total investment in these countries, the data show that a significant part of available investible resources is allocated to the creation of SOC. To understand its role in the development process is therefore of great relevance in the making of development plans.

Role in economic development. The importance of SOC in the development of an economy rests on several considerations. Its creation results in reduced costs for a wide range of producing units and may thereby encourage the expansion of existing units and the creation of new ones. The encouragement may be especially strong in those instances where the SOC creates external economies and the user of the service pays less than its value to him and possibly pays nothing at all directly for the service. For example, the construction of a new hard-surface highway in an area where previously only a dirt road existed is expected to reduce transportation costs directly. It may also reduce the appropriate size of inventories a firm must carry, as well as extend the geographic size of the firm’s market. All of these freely available economies may be expected to add to the firm’s profitability and thereby induce expansion. Thus a common strategy of planning is for the government to concentrate its own resources on the building of SOC and to rely on the private sector to respond to the incentives created by the new SOC. In this kind of strategy, the influence of investment in SOC on the development process depends largely on the extent to which the other sectors respond to the new profit opportunities.

The heavy dependence of the success of such a strategy on the ability of nongovernmental sectors to perceive and respond to the new opportunities has led a number of economists to question the effectiveness of a development program built around the argument of the preceding paragraph. In a contrary approach, the assumption is made that the chief obstacle to the development effort is not a lack of investible resources as such, but rather an inability to perceive and exploit newly arising profit opportunities.

The argument is further made that the opportunities produced by new SOC are neither clear enough nor demanding enough to induce the formation of the directly productive capital necessary to make the creation of the SOC profitable to the community. On the other hand, if the directly productive capital is constructed (possibly by the government) before the SOC, the need for the latter will be so evident to all observers that pressures— pecuniary and otherwise—will develop that force the building of the SOC. The conclusion then follows that if the time sequence of investment projects is directly productive capital first, then SOC, total investment will be larger and the development program more likely to be successful than if the sequence were the other way. The question is one of sequence of investments, not of whether SOC is required for development.

The empirical questions in this conflict of strategies have to do with the validity of the assumption about the ability of economic agents in the developing country to perceive and exploit economic opportunities and the extent to which resource limitations constitute a prior barrier to development. The situation will not be the same in all countries or even in the same country in all periods as development proceeds. Within the constraints of present knowledge the only safe generalization seems to be that the best strategy depends very much on the situation prevailing at the time the plan is made.

Few, if any, development programs accept either strategy completely. Much the most common practice in arriving at decisions on the size and timing of SOC in development plans is for the planners to estimate the directly productive capital formation to occur, and then to estimate the requirements for SOC services if the full advantages of the directly productive capital are to be realized. Thus a “balance” between SOC and directly productive capital is sought, of such a nature that there is no unusued capacity in either type of capital good and the directly productive capital is not forced to operate at extremely high costs. In the forecasting of directly productive capital formation some emphasis is placed on inducements created by the assumption that whatever SOC is needed will be available. At the same time other inducements are introduced as well, and the possible inducement effect of SOC is not the key to the plan’s effectiveness.

That this balance is frequently not achieved is evidenced by the existence of excess capacity in both kinds of capital in most developing countries. Thus in one developing country a manufacturing plant may operate below capacity because of an inadequate supply of power or because the transportation network cannot provide a steady inflow of raw materials. In another country or another part of the same country a large irrigation facility may be virtually unutilized because no further directly productive capital has been created by the individual farmer units for whose use the irrigation facility was built.

The empirical evidence suggests that neither role attached to SOC in the development strategies outlined above is alone sufficient to assure an appropriate rate and composition of capital formation. The formulation of development plans that accomplish the task of producing that quantity of SOC services that will enable the directly productive capital to operate at planned capacity and planned costs is difficult, not only because of technical indivisibilities in the production of SOC but also because of the difficulty of appraising the need for these services. To do the latter includes trying to appraise the inducement effects of the creation of SOC.

Along with its role in the problem of balance in the composition of output, investment in SOC also has important consequences for the regional pattern of development within a country. The creation of an SOC facility in one part of a country will necessarily give advantage to that area over other areas in attracting further capital formation. Since the high initial costs prevent supplying appropriate SOC simultaneously to all areas of the country, some regions of the country will lag behind others. The immediate effects of regional imbalances are social and political, but efforts to prevent or alleviate these imbalances also have effects on the rate at which the economy is able to develop. There are, of course, many factors that affect the pattern of regional development, but the building of SOC is perhaps one of the most strategic and the one most susceptible to control by central authorities.

A problem associated with SOC that has long occupied the attention of economists is that of the pricing of the services provided by such capital. The general dictum to equate price to marginal cost is not as widely accepted now as it was prior to World War II, largely as a result of developments in the theory of welfare economics [seeWelfare economics]. The price equal to marginal cost case is especially vulnerable in a declining cost situation where a subsidy is necessary to make up the difference between price and average costs. In this case the economy must be taxed to subsidize the unit utilizing the SOC service, and the welfare implications of such a tax and subsidy are extremely difficult to establish. Although there is ample evidence that the average costs of SOC services are frequently not covered by the price paid by the user of the service, there is little evidence of conscious effort at marginal-cost pricing among the countries pursuing development plans. On the other hand there is evidence that some of the services of SOC are provided at a cost meant to encourage expansion of use by the private sector, but the argument supporting such a policy is rarely the marginal cost argument. This particular problem of pricing has not, however, occupied a great deal of the attention of individuals working on the problems of development, and to introduce explicit welfare considerations greatly complicates its solution. At the same time the practice actually followed in pricing SOC services has major repercussions on the role that this capital plays—for example, in inducing expansion in the private sector—in the development process.

Areas of research. Empirical research into the effects of the construction of SOC on economic development is difficult because of the indirect nature of the returns to be realized. For example, measurement of the inducement to further investment produced by the creation of SOC can be accomplished only in a rough and ready fashion. The major need, however, is for empirical data on just this kind of question. As an increasing number of large-scale projects are completed, data may become available that will permit testing the effects in a more satisfactory manner than has been possible in the past. Such data are necessary before firm views can be established on how much SOC to provide, on the timing of its construction relative to that of directly productive capital, and on the most effective pricing policy for a country to follow. Until these data are available, the large source of potential error in the allocation of scarce investment resources will continue to plague the development programer.

Henry J. Bruton

BIBLIOGRAPHY

In addition to the works cited below, consult the serial publications of the Economic Commission for Latin America, the Economic Commission for Asia and the Far East, and the Economic Commission for Africa—all of the UnitedNations; also the published development plans of any of the developing countries.

Graaff, Johannes de Villiers 1957 Theoretical Welfare Economics. Cambridge Univ. Press.

Hirschman, Albert O. 1958 The Strategy of Economic Development. New Haven: Yale Univ. Press.

Nurkse, Ragnar 1953 Problems of Capital Formation in Underdeveloped Countries. New York: Oxford Univ. Press.