Development planning

and project analysis I

Chapter 4
Quantitative development planning
techniques

The model is then used to

Are different planning models, calculate a feasible or consistent
which specify in quantitative terms solution, defined as a set of values
the relationships between for the policy instruments that
objectives, constraints and policy satisfies the specified objectives
instrument variables. and does not exceed the
predetermined constraints.
Characteristics of development planning techniques
• The process of planning involves the examination of a host of social and
economic variables.
• These socio-economic variables are related to one another in a very intricate and
complex manner and our understanding of the long chain of interaction
becomes hazy without the aid of an analytical model.
• Models are needed, therefore, to analyse complex interactions between various
elements which may appear to be unrelated.
• Models are essential aids to clear thinking. they can make explicit of what is
implicit, vague and self-contradictory.
• planning models also have ‘communication’ value. a planner can communicate
with politicians, bureaucrats.
• A planning model specifies the relationships between the goals of the society and
the instruments that are available to achieve them.
Some of the model characteristics include
• Coverage: In terms of coverage or scope, planning models can be classified into:
• (I) overall or national models,
• (II) sectoral or regional models,
• (III) special models and
• (IV) project analysis.
 The overall models deal with the entire economy and the nation’s development
strategy is analysed within them.
 The sectoral and regional models deal with individual producing sectors and
regions and can be used to examine the consistency and feasibility of the overall
objectives.
 The special models are designed for selected aspects of the overall plan, e.g. foreign
trade or manpower development.
 Plans are ultimately implemented through projects, and it is at this stage that project
analysis is used to examine the choice of techniques, location and size of plants
within the overall objectives of the national plan. The technique that is most widely
used for this purpose is social cost-benefit analysis.
• Aggregation: Planning models can also be classified in terms of the degree
of aggregation:
• (I) aggregate models,
• (II) main-sector models and
• (III) multi-sector models.
• The aggregate models treat the entire economy (or a region, depending on its scope or
coverage) as one producing sector and are concerned with the forecasts of such major
national accounts aggregates as savings, investment and gross national product (GNP).
The most representative example of this type is the Harrod-Domar model.
• The main-sector models divide the economy (or a region, as the case may be) into a
few producing sectors and examine the interrelationships between them. Early
examples of main-sector models can be found in Arthur Lewis’s dual economy
hypothesis which dichotomized the economy into a traditional (agricultural) and a
modern (manufacturing) sector.
• The multi-sector models divide the economy or region into a large number of
producing sectors. The core of such models is the Leontief input-output analysis.
• Time: There are two aspects of the time dimension in planning models. The first
is how far into the future a model is designed to project and the second is
the way time is treated within a model. With respect to the first criterion,
we can distinguish three broad types of planning models: (i) short-term,
covering 1–3 years; (ii) medium-term, covering a 3–10 year horizon;
and (iii) long-term, extending to 10 years or more.
• In the treatment of time, models can be either
• (I)static or
• (II)dynamic.
• The static models compare one future date with the present: they indicate the
future values of the model variables but do not describe the path of the
economy between the starting and end periods.
• In contrast, the dynamic models incorporate endogenous variables from a
number of time periods and provide information on the nature of movement
of the economy from the present to some target year. Since the analysis of
dynamic models requires a knowledge of difference or differential
equations which are fairly advanced in level, these models are not
• Behaviour: Planning models be as either stochastic or
classified deterministic systems,
can depending in which
relationships the
on are treated.
way behavioural
• In the stochastic models, behavioural relationships, e.g. savings and
investment, are estimated by using econometric models which allow
for stochastic or random disturbances. Short-term macroeconomic models
are in general stochastic. Hence results obtained from such models must
be treated as probabilistic.
• In contrast, deterministic models, such as the open input-output system, do not
specify any behavioural relations and instead treat them as exogenously
or administratively determined.
• Closure: planning models can be classified into (i) open systems, (ii) closed or
fully determined systems and (iii) partially determined systems.
• An example of the open system is the input-output model which treats the final
demands as exogenous or given (i.e. not explained within the model).
• However, the final demands can be endogenized by using some form of Engel
curve or demand function, linking expenditure with income. In this case, all
the variables or unknowns can be calculated within the system once certain
policy variables are specified, and the model then becomes
‘closed’, or fully determined. These models are commonly known as
simulation or forecasting models. The simulation models provide
alternative scenarios for different possible sets of policy or exogenous
variables and thereby help evaluate outcomes of alternative policy
measures.
• However, in some cases the solution of the system is not determinate. That is,
more than one value of the unknowns is possible for a given set of exogenous
or policy variables. In that case, some sort of optimization technique must
be used to choose the set of values which maximizes the objectives of the
overall plan, given the constraints. Linear programming is the technique
• Accounting framework: Every economic model must satisfy some definitional
equality, known as an identity. This follows from the fact that all models
have either an implicit or an explicit accounting framework. This is because
every income must be matched by corresponding outlays as every receipt is
also an expenditure.
• For example, the national income accounts yield the macroeconomic identities,
(e.g. GNP is the sum of final expenditures) required to close the aggregate
models. Accordingly, the aggregate models can be classified as national-
accounts based models. Similarly, the main-sector and multi-sector models are
input-output-accounting-based models.
• Models that make use of identities derived from the accounting frameworks are
generally referred to as consistent models. This is because the accounting
identities imply consistency between sectoral supplies and total supply and
between total supply and total demand.
• The consistency models do not in general contain any ex ante welfare or
optimization functions and guide resource allocation according to
some prespecified goals without examining whether these are optimal outcomes.

• As opposed to consistency models, there are programming models which allow

for inequality relationships and deal with optimum and efficient allocation
of scarce resources.

• The Harrod-Domar and the two-gap models are aggregate where as the input-
output model, the social-accounting-matrix-based and linear
programming models are disaggregated models.
Aggregate consistency models
• The well-known aggregate consistency models are the Harrod-Domar (H-D)
model and the two-gap model.
The Harrod-Domar growth model
 In drawing up a development plan, the usual first step is to assess the
aggregate rate of growth of the economy that can be attained within the
prevailing socio economic conditions.
 The possible overall rate of growth can most easily be determined by
analysing the past and present relationships between such aggregate variables
as gross domestic product (GDP), consumption, savings, investment and the
rate of population growth.
• The basic H-D model can be summarized as follows. We make the following
assumptions.
 Harrod-Domar Model
 Harrod- Domar states that the rise in GDP from period t to period t+1 is determined by the net
amount of new capital formation in period t and its productivity measured by the inverse
capital output ratio.
 Net investment (In) is assumed to be limited by the level of saving (S), which in turn is
functionally related to the level of income (Y) through a propensity to save (s).
 The model also assumes a stable capital output ratio. The basic model can be summarized as
follows.
1) S= sY = the saving function
Where S = level of saving
s = average
propensity to save Y = Income
2) K = kY = Capital stock income relationship
Where K = Total capital formation (Stock)
k = incremented capital output

2a) 𝛻𝐾 = 𝐼 = 𝐾𝛻𝑌 where𝐼 = 𝐾𝑇+1-𝐾𝑡 =

ratio
Harrod-Domar Model
3) It is assumed that 𝑠 = 𝐼 = Δk i.e. investment is change in capital.

𝑠 = 𝑠𝑌 = 𝑘Δ𝑌 = Δ𝐾
Substituting 1 and 2a in 3 we get

4. 𝑠𝑌 = 𝐾Δ𝑌 Rewriting it yields the final expression of H-D model. That is

or

5. 𝛻𝑌𝑌 = 𝐾
𝑆
or 𝑔𝑟𝑜𝑤𝑡ℎ = 𝑌
𝛻𝑌

So 𝐾𝑔 = s=saving ratio
Where
𝑆

K=capital output ratio

•Equation 5 is the fundamental equation of the H-D model, which indicates that
given the statistically computed values of s and k and assuming their constancy, the
maximum 𝑆
growth of GDP in the economy by the ratio of � . The model helps the planner also to
predict the required savings rate once target growth
� rate and the capital output ration (k)
are given.
Harrod-Domar Model

1. Suppose the population of Ethiopia is expected to grow at 3% and the

planners would like to achieve a steady 4% rise in per capital income.
Further it is given that the aggregate capital output ratio (k) for the economy
is 3. What should be the required saving rate to achieve the given target?
• In many developing countries, the savings rate s is quite low and k is high,
implying inefficiency of investment. Hence the growth of the economy is
low and may be insufficient to absorb a rapidly growing labour force.
• It becomes necessary, therefore, to accelerate the growth of the economy beyond
the limit set by the historical values of s and k. The planning problem
begins here. It involves two issues: (i) fixing the target and (ii)
determining how to achieve it.
• Obviously the target growth rate must be sufficient to absorb the growing labour
force. For example, if the population is expected to grow at 3 percent per
year and the planners would like to achieve a steady 4 percent rise in per
capita income then GDP must grow at 7 percent annually. If we assume

can be calculated from the fundamental equation (5) as 𝑔

an aggregate capital-output ratio k of 3 then for a 7 percent target growth
of GDP rate
savings the required
= s = 0.03*0.07 = 0.21 hence 𝑔
𝑆
�
�
Then � − depreciation − population �
�
=That is, 21 percent of GDP must � growth
be saved so that actual saving is equal to the
planned investment required to achieve a 7 percent growth of GDP.
• This is the basis of Arthur Lewis’s comment that the crux of the development
problem is to raise the proportion of national income saved from 4–5 percent
to 12–15 percent.
• The next question, therefore, is how to raise the savings rate. There are three
main sources of domestic savings:
I. Personal savings,
II. Business savings and
III. Government savings.
• Most of the planning exercises emphasize the need to raise the government
savings through taxation and thereby restrict consumption to fill the financial
gap between actual savings and required investment.
• This presumes that savings cannot be raised significantly from the other two
sources as they are largely voluntary in nature. But taxation is a financial matter
which falls outside the domain of the planning agency.
• Since capital is seen to be the limiting factor to growth, the cost of capital (real
interest rate) in the developing countries is often kept deliberately below
the market rate.
• As Gurley and Shaw (1955) and McKinnon (1973) have pointed out, this
deliberate credit rationing policy, instead of encouraging private
investment, leads to the misallocation of investible funds and results in a
higher capital- output ratio k.
• At the same time, a low (and in an inflationary situation, a negative) real interest
rate discourages private savings, resulting in a low savings rate s. Thus,
the Gurley-Shaw-McKinnon hypothesis provides us with a clue to the
historically low s/k ratio.
• This policy-induced distortion is compounded in an underdeveloped economy
characterized by the existence of a large non monetized sector. In such
an economy the absence of well-developed financial institutions means
that a significant portion of the real investible surplus over
consumption is not transformed into financial capital. Thus, two policy
implications follow.
1. ‘Liberalize’ the financial market, i.e. allow the interest rate to rise to its market
equilibrium level. To the extent that the low value of s/k is due to
policy- induced distortions, this will improve the economy’s growth
potential by encouraging private savings and improving the efficiency
of capital.
2. Develop financial institutions which will mediate between savers and
investors. Given adequate financial incentives, the accessibility to banks
and other financial institutions is likely to tap the surplus over consumption
which would otherwise have found its way into either hoarding or
precious metals. Therefore, the programme for financial reforms should be
an integral part of development planning.
 If the mobilization of domestic savings through taxation and financial reforms is
not enough to finance the required investment, the savings-investment gap can
be closed by foreign savings. This can be seen quite clearly from the following
familiar national accounts identity for an open economy:
 Y = C+I+G+X-M 6
Y = C+S+T 7
• where Y is gross national product (GNP), C is consumption expenditure, I is
gross investment expenditure, G is government expenditure, X is the quantity
of exports, M is the quantity of imports, S is the amount of savings, and T is
the tax revenue. From (6) and (7) it follows that
I-[S+(T-G)] = M-X 8
that is
Investment – (private savings + government savings) = current account
surplus/deficient.
From the above identity the financing options become clear. In a closed economy,
if investment is to rise and private savings cannot be raised substantially then the
only option left is to increase government savings through taxation. But in an
open economy there is an additional option. The gap between the ‘required’
investment and ‘actual’ domestic savings can be financed by a deficit in the
current account (the gap between imports and exports).
The Two Gap Model
• The previous section showed how foreign savings could meet a short-fall of
domestic savings and enable the ‘required’ level of investment to be
undertaken.
• Consideration of the role of foreign savings in the growth process is the main
focus of the two-gap model developed by Chenery and associates (Chenery
and Bruno 1962).
• When external finance either grants or loans supplement domestic resources,
then we have “the Two-Gap model”.
• The major assumption of this model is that most developing countries either
face a shortage of domestic savings to augment for investment opportunities
or they (developing countries) are faced with foreign exchange constraints
to finance the needed capital and intermediate goods.
The Two Gap Model
Essentially, the two gap model is based on the gap between a country's own provision of
resources and its absorptive capacity. These two gaps are known as the Savings Gap and
the Foreign Exchange Gap. Whichever of the two gaps is binding (or is the greatest) will
constrain the amount of investment and capital formation, which can be undertaken.

The Savings Gap: Where savings fall short of what can be

effectively and productively invested.

The Foreign Exchange Gap: Where earnings of foreign exchange fall short of
the amounts needed to purchase the necessary foreign materials,
components, etc.
• In order to derive the two gap we start with the basic macroeconomic identity where aggregate output
=

𝑌 = 𝐶 + 𝐼 + (𝑋 − 𝑀 )
aggregate expenditure. Thus, assuming that there is no government sector
assuming no government role
Where Y= GNP; C= Consumption; I= Investment (or Domestic Capital
formation) X = Exports; M = Imports
Now,
𝑌+
Sources of resources used in 𝑀 = = Uses𝐶of+resources
the economy 𝐼 in the economy:
expenditure C from both sides we get: + 𝑋
𝑌−𝐶 𝐼
Subtracting

Since 𝑌 − 𝐶 = 𝑆 Where: + 𝑀S = Savings +𝑋

=

𝑆+𝑀 𝐼+𝑋
(domestic) Then,

(Injections)
= investment can be financed by domestic saving as well as through inflows of
This implies that domestic
𝑆−𝐼 𝑋−𝑀……………….…………………………
capital. But these two constitute two separate constraints. Eliminating one does not get rid of the other.
(Withdrawals)
=
(2)

𝐼−𝑆=𝑀−𝑋……………………………………………………………………
(Saving gap) (Foreign exchange gap)

… … … . (3)
• Note: The analysis rests on the premise that domestic investment can be
financed by domestic saving as well as through inflows of capital.
• If we let (M – X) = F, then we can represent the above as follows
• F = I – S or as in the text I = F + S
• Possible Scenarios
• Using the relationship posited above, the following scenarios may arise:
• S may be too small to permit the amount of I that the country would otherwise
have the capability to undertake. Therefore, a savings gap would exist.
• X may be too small to permit the M required to make full use of the resources
of the economy. Therefore a foreign exchange (or trade) gap would exist.
• While the two gaps are distinct and separate ones, international transfers can, in
fact, be used to fill both.
• For example, a machine given to a country represents both an import for which
no resources need to be exported (thus alleviating the foreign exchange gap)
and an investment good which does not have to be offset by domestic
saving (thus alleviating the savings gap).
• Assessment of the Two Gaps
• Even though, according to the national accounts identity, the ex post investment-
savings gap must be equal to the ex post import-export gap, there is no
reason for these two gaps to be equal ex ante (in a planned sense).
Therefore, the investment-savings and import-export gaps (ex ante) can be
written as
In some of the work done on the two-gap model, it is suggested not only that
they exist but that, most often; the trade gap exceeds the savings gap. This
suggests that the trade gap is more powerful - i.e. is the binding constraint.
• Thus, it is intuitively clear that if the target growth is to be achieved, foreign
capital inflow must fill the larger of the two gaps so that the bottleneck can
be avoided.
• Developing countries are often found to suffer from the ‘foreign exchange
constraint’ (i.e. the import-export gap is larger than the investment-savings
gap).
• In this situation, the willingness to save is frustrated by the inability to acquire
imports which are required to produce investment goods. That is, a portion
of the maximum potential domestic savings remains unutilized in the
presence of a constraint imposed by the availability of foreign exchange.
• This conclusion, however, crucially depends on the assumption of no
substitution between foreign and domestic resources; in other words, if
foreign exchange is scarce it is impossible to use domestic resources
to earn more foreign exchange.
Critics
• Critics of the two-gap model have argued that developing countries should be
able to transform surplus domestic resources into export production.
• But, as Thirlwall (1983:295) has put it: ‘If it were that easy, the question might
well be posed, why do most developing countries suffer from chronic
balance of payments deficits over long periods despite vast reserves of
unemployed resources?’
• Critics have also pointed out that, instead of supplementing domestic savings,
foreign aid/exchange may substitute for it, if foreign aid relaxes the
domestic savings effort.
• It is also argued that foreign aid has allowed governments to delay making
difficult decisions regarding domestic resource mobilization.
Disaggregated Consistency Models
• The planning exercise does not stop at the most aggregate level with the setting
of a GNP growth target and the calculation of required investment, savings
and foreign capital inflows.
• As mentioned earlier, the whole process proceeds in stages, and the second
stage of the planning exercise usually involves a further breakdown of
the plan to cover a number of strategic sectors of the economy.
• The economy is the sum of the individual sectors, so the target growth of GNP
will imply specific rates of growth for the component sectors.
• The second stage therefore involves the translation of the overall growth
target and investment requirements into sectoral growth targets and
investment requirements.
• This is the concern of disaggregated consistency models. In this chapter we
consider models such as the multi-sector model.
Multi-sector models: Input-output analysis
• At the core of a multi-sector planning model is the input-output analysis. The
essence of the input-output analysis is that it captures the interrelationships
of the production structure arising through the flow of intermediate
goods.
• There are numerous uses of the input-output technique and it is the most widely
used planning tool.
• The most common uses of it for planning purposes can be summarized as
follows.
1) Being a consistency model, the input-output technique can be used for
projecting and forecasting sectoral production or supply requirements to
meet the sectoral demands implied by alternative targets for GDP.
2) Once the sectoral supply is projected, the analysis can be extended to forecast
the requirements for (a) primary factors, e.g. skilled labour, (b) sectoral
capacity expansion and investment and (c) non-competitive imports.
Multi-sector models: Input-output analysis
3)Since the input-output table contains information on intermediate
transactions between the producing sectors, it can be used to identify the ‘key’
sectors with maximum interdependence.

4)The input-output table can also be used to forecast the impact of supply
shocks and cost inflation.

5)Finally, the input-output technique can be applied to-determine

comparative advantages. Each of these uses will be discussed in greater detail
at subsequent stages.
Input–output analysis and its application
• Input-output is a novel technique invented by Professor Wassily W.Leontief in
1951.
• It is used to analyze inter industry relationship in order to understand the
interdependencies and complexities of the economy and thus the conditions
for maintaining equilibrium between supply and demand.
• Thus it is also known as “inter industry analysis.”
• The basic notion of input output analysis rests on the belief that the economy
of any country can be divide in to a distinct number of sectors called
industries each consisting of one or more firms producing a similar but not
necessarily homogeneous product.
• Each industry requires certain inputs from other sectors in order to produce its
own output.
Input-out put analysis and its application
• Similarly, each industry sells some of its gross output to other industries so that
they too can satisfy their intermediate material needs.
• In other words, the input of one industry are the outputs of another industry and
vice versa, so that ultimately their mutual relationships lead to equilibrium
between supply and demand in the economy as a whole.
• The term input is something, which is bought for the enterprise while an
output
is something, which is sold by it.
• An input is obtained but an output is produced. Thus inputs represent
the expenditures of the firm while output represents its receipts.
• The model uses the concept of matrices algebra in the analysis.
Main Features of the Model
• Usually the input-output technique describes the general equilibrium analysis
and the empirical side of the economic system of production of any
country.
• As such it has three main elements.
• First, the input output analysis concentrates on an economy, which is in
equilibrium.
• It is applied for an economy in which input equals output or in other words
consumption equals production i.e. the model assumes that whatever is
produced is always consumed.
• It is not applicable to partial equilibrium analysis.
Main Features of the Model
• Second, it does not concern itself with the demand analysis.
• Utility functions are omitted. And consumer demands are stated on the basis of
outside information without regarding to the equilibrium of individual consumers.
• The model deals exclusively with technical problems of production i.e. what can be
produced and how much quantity of raw materials should be utilized in the production
process.
• Lastly, the model is based on empirical investigation.
• The analysis seeks to determine what can be produced, and quantity of each
intermediate product, which must be used up in the production process, given the
quantities of available resources and the state of technology.
The assumptions of input – output Analysis
• As the word is Very complex, it is difficult to have a model, which expresses all
things fully.

• Thus most of the models in economics are constructed taking the basic
assumption ceteris paribus and other assumptions.

• Taking this fact, therefore, before we are going to deal with the details of the
input- output analysis, it is important to note the basic assumptions.
The assumptions of input-output Analysis
• The assumptions that the I-O analysis includes are the following:
• An economy is decomposed in to n sector (industries) and each of these produces only
one kind of product i.e. no two products are produced jointly.
• The total output of any industry is capable of being used as inputs by other inter- industry
sectors, by itself and by final demand sector.
• There are constant returns to scale. This is the crucial assumption of input- output analysis
i.e. the one that makes the system operationally effective. This assumption implies that
in any productive process all inputs are used in fixed proportions and increase in inputs
is in proportion with the level of output.
• Prices, consumer demands and factor supplies are given
• There are no external economics and diseconomies of production.
• All transactions may be considered in terms of money value since money is a
suitable common unit for aggregating inputs and out puts of industries.
The Structural Nature of an Input-Output System
• As it indicated above input- output analysis emphasized general equilibrium
phenomena and it is based on the belief that an economy consists of
different sectors, which are interdependent to each other.
• So that each industry employs the output of other industries as its raw
material. Its output
in turn is used by other industries as a productive sector. In other
words it implies there is transaction between industries.
• Thus the input output model can be portrayed by table (more formally, a
matrix) that shows how the output of each sector is distributed in the form of
intermediate products, for itself and for other sectors and as final product to
households, government and export.
• Each sector is indicated in the table both as purchaser and supplier of a
product.
• The input output table is therefore important in the analysis by providing a
convenient framework for measuring and tracing these interindustry flows
of current inputs and outputs among the various sectors of the economy.
• A table summarizing the origin of all the various inputs and the distribution
of all the various outputs of all industries in an economy is therefore
known as input output table.
• The framework of the input output table is generally represented as follows and
is indicated in the table that follows.
• Most of the important information contained in the table is located with in
four main quadrants (Blocks):
I. Block I (Inter industry Transactions block)
II. Block II (Value added quadrant)
III. Block III (Final use block)
IV. Block IV (Direct factor purchase quadrant) - This quadrant is not as
important for planning purposes as the other three although it is necessary
for accounting purposes specially for measuring gross domestic product.
• Block I shows the supply of output from one sector to another for use in the
production process of each sector.
• The producing sectors of the economy are listed as rows 1, 2, - - -, n in this
quadrant while these same industries is also listed by column as using sectors.
• Thus the inter industry transaction quadrant is a " square matrix " with the
same number of rows as columns, one for each sector of the economy.
• Each row shows the distribution of outputs of a sector to other sectors and each
column shows the receipt of an industry as an input from other sectors and
itself.
• In short rows indicate outputs, columns represent inputs and each sector is
• Block III shows the final demand use of the sectoral output, products,
which are consumed for their own sake and not for use in further
production.
• They may be purchased as consumption goods by individual consumers or
by the central government or they may be sold to foreign demanders in the
form of exports.
• The horizontal summation of the outputs of the sector sold as intermediate
goods to the other sectors plus the output sold to private, public and
foreign final demanders yields the total output of the given sector.
• Block II shows the primary input (land, labour, capitals) required by each sector in the
production of its output.

• The sum of value of these primary inputs used in the whole economy yields the total value
added by the sectors.

• For any particular sector the elements in each column of this block when added to the
elements in the corresponding columns of the transactions block yield a value for total
inputs purchased or used up by this industry during the accounting period i.e. the total
cost of operation.

• Block IV- shows those primary inputs, which are employed by final users.

• The main component of this quadrant would be the purchase of labour services the
central government, households for their own consumption.

• Dear student! The scheme of input-output is shown in the table below.

• As shown in the input output scheme of the above table the value of total
output equals the value of total input i.e. the horizontal summation of the
elements in each row equal to the vertical summation of elements in each
column to which the sector is represented.
• For instance X1 indicated in row I equal X1 indicated in column 1 of sector 1.
What is the reason for that?
• Have you tried? That is nice.
• The reason is the basic assumption of the input output analysis that an output
produced by each sector is used as an input for others, for itself and as final
demand, so that production equals consumption and it is always true for
this model.
• Because I-O model is applicable only for an economy which is in equilibrium
not for partial equilibrium.
• The elements in each row show the distribution of output to various sectors and
uses while the data in a column indicate the sources of inputs needed for
production. For example reading across the first row, altogether the agricultural
output is valued at birr 300 per year, of this total, birr 100 worth of goods go
to final consumption (house hold and government consumption, investment
and export). The remaining output from agriculture goes as inputs 50 to itself,
150 to manufacturing.
• The sum of total intermediate and total final demand yields a gross output for
agricultural production of birr 300 worth. Similarly, the manufacturing
produces a total output of value birr 500, of which birr 250 worth of goods is
goods is sold to other sectors and used by itself as an intermediate input,
the rest birr 250 worth of the output of this sector is used for final
consumption 50 for household, 80 for the government, 80 for investment and 40
for export demand. The disposition of the total outputs of the other three
sectors can be read of the table in the same manner.
• The elements in each column show the input or cost structure of the sector.
• For instance reading down in the first column we see that in order to produce its
total output of birr 300 worth of goods, agriculture uses 50 of its own output,
100 from manufacturing.
• Thus total intermediate purchase of the agricultural sector equals 150.
• The remaining 150 birr worth of total inputs purchased consists of the
importation of 15 birr worth of foreign goods and the creation of 135 birr worth
of value added in the form of payments of birr 10 to the government as taxes,
75 to house holds as wages, 20 for the use of capital in the form of interest,
and 30 birr for the use of land in the form of rent.
• Thus the value of the total output of agriculture is equal to the total value of
all inputs purchase i.e. the sum of intermediate inputs purchased and the
primary inputs used. The same procedure can be followed for other
sectors.
• As you have learned in your macroeconomics course in order to compute the
GDP we can use either the income or the product approach of national
income accounting and can arrive at identical result.
• Let you try to compute the GDP from the above hypothetical example.
• Have you tried? It is nice
• Using the income or value added approach; GDP is determined as the
summation of total payments (both intermediate and final) to primary
inputs plus business tax payments.
• These total payments amounted to 465. i.e. 35+55+250+75+85.
• Using the product approach, which defines GDP as the difference between total
final demand (100+250+100+50 = 500) and intermediate imports (35) we
arrive at the same figure of 465.
The mathematical Input-output model
• So far we have been concerned with a descriptive explanation of the input output
table.
• However, the major theoretical and practical value of input output tables is that
they can easily be transformed in to a consistent mathematical model and
utilized either as a forecasting tool to predict the effects of autonomous changes
in final demand on total output and employment in all sectors of the
economy.
• In order to transform this input output or accounting table in to a use full
mathematical model, however, the model has taken certain assumptions of this
constant returns to scale (fixed input coefficient) is crucial for the model.
• Therefore, before going to the details, here use will try to see how to drive input
coefficients from the inter industry transaction block of the table (block I).
• These coefficients are also known as input-output technical coefficients. These
coefficients show inputs per unit of output for a given sector. This is done
very simply by dividing each column entry in the matrix by the sum of the
column.
The Dual Foundation of the Basic Model
The Leontief Matrix
• You have learned about Leontief matrix, its inverse and its application. Do you
remember how it is computed and how the inverse of a matrix is found?
• If your answer is yes, please try to find the Leontief matrix and its inverse for
our hypothetical input-output table and relate your answer with the figures
given below.
• If not please refer books on matrix algebra, for easy understanding of the
coming analysis.
• Matrix algebra is an important tool for input output analysis.
• There fore, in this section we will try to show how a general solution is arrived
at using the concept of elementary matrix algebra. For this we start from
equation 4 given above i.e.
• Calculate the inverse of the Leontief matrix for our hypothetical example
• Initially in our hypothetical example the total final demand for the outputs
of the three sectors was 450, the new final demand is 600 =
(150+300+150), an increase by 150.
• Due to this increment in final demand total output has increased by 346 from
1100 of the initial total output of the three sectors i.e. 1445.85 = (408.15
+629.85+408.15) minus 1100.
• The difference of these total output change (346) and the change in final
demand (150) is to be used as an intermediate input which equals 196.
• For example in order to produce the new level of gross output of 408.15 the
agriculture sector requires to purchase:
• 0.17X408.15=69.39 from agricultural sector
• 0.33X629.85=134.69 from manufacturing
• 0.00X408.15=0.00 from service
• Calculating with the same procedure for other sectors i.e. by multiplying
per unit input requirement (input coefficients) by the new total output the
transaction block (block I) has the following values.
Agriculture Manufacturing Service
Agriculture 63.39 188.86 0.00
Manufacturing 134.69 125.94 69.39
Service 0.00 188.94 69.39

If the final demand is added to this intermediate we obtain the new gross
output of each sector.
For instance for agriculture sector the total intermediate use is 69.39+188.865
while final demand is given as 150. Thus the total output is 408.15.
Use of Input-Output Analysis in Planning
• As you see in the previous discussion the input output analysis tells us about
the inter relationships between various sectors and the structural relations
with in each factor.
• The basic concept of input output analysis has been adopted by many countries,
which have undertaken programmes of economic development.
• The most important questions that may be raised in planning a given
economy includes, what level of total output, what will be the level of
employment and what will be the balance payment position of the country
by the coming plan periods etc.
• Considering this and other questions and the basic concept of the input
output analysis discussed what importance would the model has. Would
you explain the roles of the model?
• The input output analysis can help planners:
1) To for cast the sectoral output needed to sustain a given desired level of final
demand.
2) To forecast the primary factor or resource required to produce the given
level of sectoral output.
3) Forecast capacity expansion (investment requirements) consistent with a
given growth target if information is available on incremental capital
output ratios sector by sector.
4) To for cast import requirements and the balance of payments effects of given
changes in final demand.
Limitation of Input Output Analysis
• Despite its obvious advantages, the input output analysis cannot be wholly
accepted for purposes of planning. The assumptions set out for the discussion
of I-O analysis help us to understand the major limitations of the model.
1. The input output technique is based on the assumption of constant returns
to scale and constant technique of production in technology. However, these
coefficients may not remain constant when growth is taking place. In the long
run the validity of the assumption of a constant coefficient becomes invalid
as technical progress gains momentum, substitution possibilities arise and
returns to scale might be rising instead of being constant. Thus marginal input
coefficients might no longer be equal to the average.
2. The I-o analysis assumes that each industry has only one way of producing a
given product. But there could be more than one process or activity to
produce a commodity.
Assignment
1. A simple economy has three sectors Agriculture, industry & service. Suppose
that the final demand for agriculture, industry & service sector are birr 30,birr
250 and 120 worth of the three sectors respectively. It is given that a birr worth
of agriculture requires 10 cents, 50 cents and 15 cents worth of agriculture,
industry & service sector respectively as input; a birr worth of industry
requires 25 cents, 5 cents& 10 cents worth of agriculture, industry & service
sector products respectively as input; and that of a birr worth of service sector
requires 5 cents from it self and 25 cents & 15 cents worth of goods from
agriculture and industry respectively as inputs. Given the above information
and assuming the economy is in equilibrium answer the following questions.
Assignment
A. Determine the technical coefficient or technology matrix of the economy.
B. Determine the gross output of each sector for the given final demand.
C. Calculate the balance of payment of this economy assuming that from the
given final demand of each sector 30% is used for export purpose and from the
total primary input requirement of each sector 25% is imported from foreign
countries.
D. Determine the total output of each sector if the final demand changes to 60 for
agriculture, 300 for industry and 200 for service
E. Determine the value addition associated with the new equilibrium output
level of each sector and the new balance of payment taking the assumptions
in C
What is a SAM?
• A SAM is also a representation of the economy. More specifically, it is an
accounting framework that assigns numbers to the incomes and expenditures
in the circular flow diagram.
• A SAM is laid out as a square matrix in which each row and column is called
an “account.” Table 1 shows the SAM that corresponds to the circular flow
diagram in Figure 1. Each of the boxes in the diagram is an account in the
SAM. Each cell in the matrix represents, by convention, a flow of funds from a
column account to a row account.
• For example, the circular flow diagram shows private consumption spending as
a flow of funds from households to commodity markets. In the SAM, it is
entered in the household column and commodity row. The underlying principle
of double-entry accounting requires that, for each account in the SAM, total
revenue equals total expenditure. This means that an account’s row and
column totals must be equal.
Activities and commodities
• The SAM distinguishes between “activities” and ”commodities.”
• Activities are the entities that produce goods and services, and commodities are
those goods and services produced by activities.
• They are separated because sometimes an activity produces more than one kind
of commodity (by-products).
• Similarly, commodities can be produced by more than one kind of activity: for
example, maize can be produced by small or large-scale farmers. The values
in the activity accounts are usually measured in producer prices (that is,
farm or factory gate prices).
• Activities produce goods and services by combining the factors of production
with intermediate inputs. This is shown in the activity column of the
SAM, where activities pay factors the wages, rents, and profits they
generate during the production process (that is, value-added).
Activities and commodities
• This is a payment from activities to factors, and so the value-added entry in the
SAM appears in the activity column and the factor row [R3-C1].
• Similarly, intermediate demand is a payment from activities to commodities
[R2-C1].
• Adding together value-added and intermediate demand gives gross output.
• The information on production technologies contained in the activity column is
the input part of a typical “input–output table,” or factor and intermediate
inputs per unit of output.
• Commodities are either supplied domestically [R1-C2] or imported [R7-C2].
Indirect sales taxes and import tariffs are paid on these commodities [R5-
C2].
• This means that the values in the commodity accounts are measured at market
prices. A number of economic entities purchase commodities.
• As discussed, activities buy commodities to be used as intermediate inputs
for production [R2-C1].
• Final demand for commodities consists of household consumption spending
[R2-C4], government consumption, or recurrent expenditure [R2-C5],
gross capital formation or investment [R2-C6], and export demand [R2-C7].
• All of these sources of demand make up the commodity row (payments by
different entities for commodities).
• On their own, the commodity row and column accounts are sometimes referred
to as a “Supply–Use Table,” or the total supply of commodities and their
different kinds of uses or demands.
….
• The SAM in Table 1 shows only single activity and commodity rows and
columns. However, a SAM generally contains a number of different activities
and commodities.
• For example, activities may be divided into agriculture, industry, and
services.
• The information needed to construct these detailed activity and commodity
accounts is usually found in a country’s national accounts, input–output
table and/or supply–use table.
• All of these data are usually published by a country’s statistical bureau.
Domestic institutions
• A SAM is different from an input–output matrix because it not only traces
the income and expenditure flows of activities and commodities, but it
also contains complete information on different institutional accounts, such
as households and the government.
• Households are usually the ultimate owners of the factors of production, and so
they receive the incomes earned by factors during the production process
[R4- C3].
• They also receive transfer payments from the government [R4-C5] (for
example, social security and pensions) and from the rest of the world [R4-C7]
(such as remittances received from family members working abroad).
• Households then pay taxes directly to the government [R5-C4] and purchase
commodities [R2-C4]. The remaining income is then saved (or dis-saved
if expenditures exceed incomes) [R6-C4].
• Information in household accounts is usually drawn from national accounts and
household surveys from the country’s statistics bureau.
….
• The government receives transfer payments from the rest of the world [R5-C7]
(such as foreign grants and development assistance).
• This is added to all of the different tax incomes to determine total government
revenues.
• The government uses these revenues to pay for recurrent consumption
spending [R2-C5] and transfers to households [R4-C5].
• The difference between total revenues and expenditures is the fiscal surplus (or
deficit, if expenditures exceed revenues) [R6-C5]. Information on the
government accounts is normally drawn from public-sector budgets published
by a country’s ministry of finance.
Savings, investment, and the foreign account
• According to the ex post accounting identity, investment or gross capital
formation, which includes changes in stocks or inventories, must equal
total savings. So far we have accounted for private savings [R6-C4] and
public savings [R6-C5].
• The difference between total domestic savings and total investment demand is
total capital inflows from abroad, or what is called the current account
balance [R6-C7].
• This is also equal to the difference between foreign exchange receipts (exports
and foreign transfers received) and expenditures (imports and government
transfers to foreigners). Information on the current account (or rest of world) is
drawn from the balance of payments, which is usually published by a
country’s central bank.
Balancing a SAM
• The information needed to build a SAM comes from a variety of sources, such
as national accounts, household surveys, government budgets, and the
balance of payments.
• Placing these data within the SAM framework almost always reveals
inconsistencies between the incomes and expenditures of each account.
• For example, government spending in national accounts may not be the same
as what is reported in the government budget.
• A number of statistical estimation techniques exist to balance SAM accounts
or reconcile incomes and expenditures.
• Cross entropy estimation is generally the preferred method. More information
on this approach can be found in various IFPRI discussion papers.
Linear programming and development
•planning
The main task of development planning is to ensure that resources will be used
to meet the goals of a development programme, and that the resources are
allocated efficiently subject to certain constraints.
• Programming is a mathematical tool, which is now being increasingly used, in
economic analysis. Its use in the field of development planning is of much
interest chiefly because it helps the planners to allocate resources optimally
among alternative uses with in the specific constraints.
• At the micro level the technique could be used to find out optimal and efficient
(least cost) methods of production.
• Most of the time it deals a whole complex of ingenerated projects rather than
with a marginal project, and is concerned with much wider considerations
than marginal analysis.
….
• It provides a simultaneous solution to the three basic purposes of development
planning, which are:
• (i) The optimum allocations of resources
• (ii) efficiency in the use of resources; and
• (iii) the balance between different branches of the national economy.
• One particular programming technique which can assist in providing a
simultaneous solution to these basic questions is the technique of linear
programming. Thus here in this section we will deal with such
technique.
 Linear programming
• Linear programming is a mathematical technique for the analysis of optimum
decisions, subject to certain constraints in the form of linear inequities.
• It applies to those problems, which require the solution of maximization, or
minimization problems subject to a system of linear inequalities stated in
terms of certain variables.
• The problems of maximization and minimization are also called optimization
problems. It is a method used to decide the optimum combination output to
be produced by a given plant and equipment.
• It is also used to decide between the varieties of techniques to produce a
commodity.
• The technique involved in linear programming is similar to the technique
used in input output analysis, However, LP is more realistic than the input
output approach.
• The input output analysis a single method of production to a given commodity.
• It does not take in to account the constraints, which a development project has to
face. But in an LP problem all the possible processes or techniques are taken
in to account for achieving the desired objective.
• This might necessitate the substitution of one factor by another so the LP, as a
tool of development planning is superior to the input output technique.
• And it is considered as a powerful and complementary tool, which can be used
to analyse the I-O tables in order to solve the problems of choice of
techniques on the supply side as well as the problem of choice of final
demand.
• Most linear programming techniques have been found to be extremely useful
for sectoral planning, in respect to selecting the optimum alternative
technology and location.
• For example, the techniques have been frequently used in farm management for
determining the optimum combination of different crops and live stock.
• Similarly, transport, purchasing, assembling, production and marketing
problems are being solved through LP technique in order to minimize costs
and maximize profits.
 General Formulation of LP Problems
And Assumptions
• Four important uses (generalizations) that LP can be put in any
countries concerned with allocation efficiency are:
1. It can be used for choosing between techniques for making the same
commodity.
2. It can be used for deciding the best combination of outputs with
given techniques and factor endowments.
3. It can be used for deciding whether it is more efficient to produce
commodities at home or buy them from abroad.
4. It can be used to determine the most efficient spatial location of
activities.
 All these issues are optimizing decisions of one form or another and can be
incorporated in to the standard form of a programming problem which consists
I. The objective function- it may be maximization of profits or national income
or employment or the minimization of costs.
II. The constraints- They may be limitations of resources such as land, labour, or
capital.
III. The non-negativity conditions e.g. that outputs or exports should not be
negative
Mathematically
Max or minimize Z= C1X1C2X2+---+CnXn
Subject to  a12 X 2      a1n X n  b1
a11 X 1
 a 22 X 2      a 2 n Xn  b2
⁝ a 21 X 1 ⁝ ⁝

a n1 X 1  an 2 X 2    a n n Xn bn

and Xi  0

Where aii, bi and Ci are given constants

Assumptions of Linear Programming Technique
• The linear programming analysis is based on the following assumptions
1. The decision making body is assumed to face a number of constraints with in
which it has to operate. There may be credit, raw material and space
constraints on its activities.
2. It assumes a limited number of alternative production processes
3. It assumes linear relations among the different variables. This assumption
implies that the input output coefficients are fixed in respect of all the available
inputs and the number of products to be produced.
4. Input output prices and coefficients are given and constant. They are known
with certainty and do not change during the period being studied. For instance
profits per unit of each product, amount of resources available are fixed during
the planning period.
Linear programming Technique and its Application in Planning
• It is obvious that every country (developed as well as developing) faces the
problem of allocation of resources.
• The resources such as labour, machine material, capital etc. are available in a
limited quantity.
• Thus the optional utilization of these resources is important to achieve
a specified objective.
• An optimal decision may be a decision for maximum profit (production) or the
minimum cost.
• A linear programming model is the most widely used technique, which
provides an efficient method for determining an optimal decision (an
optimal strategy or an optimal plan) chosen from a large number of
possible decisions.
Linear programming Technique and its Application in Planning
• The alternatives may be the production of different products, the selection of
different investment strategies, to select production techniques that
maximize output (i.e. decision whether to use labour intensive or capital
intensive techniques of production etc.
• To determine the capital budget which maximizes the net present value subject
to several financial, managerial, environmental and other constraints
• In the selection of an investment portfolio form a variety of alternatives
available in such a way to maximize the return on investment or to
maximize social welfares.
• Selection of a production technique, which minimizes cost or maximizes total
output i.e. capital intensive or labour intensive etc.
Formulating an LP Problem and method of Solution
• Given the above standards forms of a programming problem, let us illustrate the
principle of linear programming, and its importance use for the valuation of resources,
by taking the case of the choice of outputs that can be produced with given techniques
subject to constraints over the availability of resources.

• Let us assume that a country produces two products: agricultural and manufactured.
Each unit of agricultural product sells at birr 1 and the manufactured product at birr 4.
It takes two workers and 4 units of capital to produce one unit of agricultural products
and 10 workers and 5 units of capital to produce one unit of manufactured product.
The total number of workers and amount of capital available are 1000 and 600
respectively.
• Given this information a planner can structure a linear program to allocate the
country’s resources (labour and capital) so as to maximize the total value of
output or GDP.
• The first step is to define the decision variables and the parameters.
• The decisions are the amounts of products (level of agricultural and
manufactured output) that the country should produce. Let X1 is the level of
agricultural output that should be produced and X2 is the level of manufactured
product. The parameters of the problem are:
• The number of workers required par unit of agricultural and manufactured
products.
• Units of capital required per unit of agricultural and manufactured
products.
• Total available amount of resources (labour and capital)
• Price per unit of agricultural and manufactured products.
The next step is to state the objective function and constraints. The
objective is to maximize the value of total output (or GDP). Therefore
the objective function is.
Maximize Y = 1X2 + 4X2
Were Y = Total value of output (total
income) 1X1 = Value of
agricultural output 4X2 = Value of
manufacture output

The constraints are on the availability of resources. That is, in producing

the two products we cannot use more of any resource than is available.
Thus the constraints take the form.

Resources used  resources

available There fore, the constraints on the information
available are:
2X 1  10X 2  1000    labour
The condition that negative amounts of neither
product can be produced implies a further constraint as:
X1  0, X 2  0    non negativily
constriant
There fore, we can summarize the country’s resources
allocation problem using a linear programming form as:
Maximiz Y = X1+4X2
e 2X1+10X2 
1000
X1,1X
4X 2  20
+5X  600
The solution to the above linear programming problem is to find the
values for X1 and X2, which will maximize Y, and at the same time
are feasible in the
sense that the attainment of these values does not violate any of
the constraints including the non- negatively conditions.
• There are two methods that can be used to find a solution for a linear
programming problem: Graphic and simplex method.
• If the numbers of decision variables are limited to two, it can be solved simply
by using graphic method. If the number of decision variables exceeds three
the simplex method is more appropriate.
 .

• Second construct the graph for the constraints. To do so,

• the first decision variable (the level agricultural output X1 is represented along
the horizontal axis and the second decision variable (the level of
manufactured output X2 is represented along the vertical axis.
• Each constraint is represented by a straight line – AB for labour and CD for
capital. The none negativity conditions are represented by the X and Y axis
i.e. X- axis for X2 and Y axis for X1.
• Third identify the feasible region or solution space. Any point on or below AB
satisfies the labor constraint; and any point on or below CD satisfies the
capital constraint.
• More over, there is no point above AB (or CD), which satisfies the
capital constraint.
• More over, there is no point above AB (or CD), which satisfies the
constraints.
• The points that will satisfy both the inequality constraints and the non-
negativity constraints are given by the area OAKD.
• Then this area is regarded as a feasible region. Because output levels to the
right of AB would require more labour than is available.
• Similarly output levels to the right of CD would require more capital than
is available. Fourth, locate the corner or extreme points.
• The area OAKD represents the set of all feasible solutions.
• The four extreme points of the feasible region are o (0, 0). D (150, 0), A
(0,100) and K (33.5, 93.3).
• Lastly, evaluate the objective function at extreme points and select the point
that would help to achieve the objective.
• The mathematical theory behind linear programming states that an optimal
solution to any problem will lie at a corner point or an extreme point of
the feasible region.
• Hence for our example the objective is to maximize income, the optimal
solution is thus that extreme point for which the objective function has
the largest value.
• Thus the optimal solution to the problem occurs at the point K = (33.5,
93.3)
i.e. X1 = 33.5 and X2 = 93.3 with the objective function value of Y =
birr 406.7.
• As it is mentioned above graphical methods of solution are applicable
to problems with only two or at most three variables.
• For the solutions to problem with more than three decision variables we need
to use the simplex method.
• However, the simplex method uses some important properties of the graphical
solution.
• First in this method one can find a feasible solution by testing whether an
improvement in the objective function is possible by moving to adjacent
corner point of the feasible solution space.
• The second point is that the optimal solution to the problem always occurs
at one of the corner points of the feasible solution space.
Simplex Method

• Assignment!!
Thank
You