l' MSU RETURNING MATERIALS: P1ace in book drop to remove this checkout from LIBRARIES . .—c—. your record. FINES WI” be charged if book is returned after the date stamped be10w. wmfififfififi .-~" ‘\ 300 A255 0929 11 A PRODUCTION APPROACH TO REGIONAL ECONOMIC INTEGRATION By Ali Abdussalam Tarhouni A Dissertation submitted in partia] fulfiliment of the requirements for the Degree of Doctor of Philosophy at Michigan State University 1983 ABSTRACT A PRODUCTION APPROACH TO REGIONAL ECONOMIC INTEGRATION By Ali Abdussalam Tarhouni To the extent that economic integration through the mobility of factors of production offers advantages in terms of economies of scale and external economies, by virtue of increasing the effec- tive size of the integrated market, it may accelerate the process of economic development. The major objective of this study, therefore, was to explore the possibility of undertaking this new avenue to development when applied to some Arab countries. The countries chosen were Egypt and Libya, whose two economies are highly complementary. Libya en— joys a large surplus of financial capital which cannot be absorbed domestically due to many constraints, of which the most important is the scarcity of skilled and unskilled labor. By contrast, there exists in the Egyptian economy a widespread labor redundancy coup- led with an acute shortage of capital. In the course of this investigation, the theoretical founda- tion of economic integration was discussed. To build the case for the mobility of capital and labor, the economic features of Libya and Egypt were analyzed. Against this background, the major hypo- thesis that was tested is that economic integration between the two countries is likely to be beneficial. The economic gain would Ali Abdussalam Tarhouni be due to higher levels of productivity of at least some of the fac- tors of production and a higher level of output. To accomplish these objectives, both theoretical and empirical analysis was employed. To evaluate the technical relationship be- tween inputs and outputs, a variety of Cobb-Douglas production func- tions were estimated for each economy, as well as for the integrated economy. The results were used to estimate the productivity of capi- tal and labor and their marginal rates of substitution. To estimate the elasticity of substitution between inputs, a transcendental loga- rithmic (translog) function was utilized. Finally, a general equili- brium approach was adopted to evaluate the "working" of the integrated economy. How will resources be allocated "efficiently"? And what is the optimal choice of output for the combined economies? The general conclusion of this study was that there is ample theoretical and practical justification for the formation of some sort of economic integration between Egypt and Libya. The reallo- cation of resources will lead to higher productivity of Libyan capi- tal, and higher productivity of Egyptian labor. There will be a significant increase in the output of each economy as measured by gross domestic product, and of the integrated economy. Acknowledgements Many individuals have contributed advice and time to the pre- paration of this thesis. I am heavily indebted to my major advisor, Professor Subbiah Kannapan, for the guidance, patience, and valuable assistance he very willingly gave to me during my research. The opportunity to work with Professor Kannapan was an invaluable edu- cational experience. Professor Daniel Hamermesh added to the quality of this re- search through careful reading and questioning of both content and method. I shall always remember with a deep sense of appreciation his interest in my personal welfare and his assistance throughout my stay at Michigan State. My deep appreciation is extended to Professor Byron Brown, who made himself readily available for consultation, and was always ready to assist. ' To my brother and friend, Faraj, my love and thanks. To the rest of my family, Fatama, Moftah, Khairia, Mohamed, Salah and Nasser, go my appreciation and love for their love, support and tolerance. To my friend and colleague, Farhang Niroomand, goes my deep appreciation for both stimulating my thoughts and for the memories of a lifetime. Without reservation, my greatest appreciation goes to my wife, Mary. She was a constant source of encouragement, and without her love, support, and understanding, the work would never have been finished. A final word must be left for the joy of my life, my daughter, Yasmine. Although she claims no contribution to the thesis -- actu- ally her cuteness was in many instances a pleasurable distraction -- her presence was the biggest motivation for me to pursue this goal, as well as many others. To my parents Abdussalam El-Tarhouni Mabroukah El-Griani TABLE OF CONTENTS Page List of Figures ............................................... iv List of Tables ............................................... v Introduction .................................................. 1 Chapter 1 - Critical Review of the Literature ................. 6 A. The Evolution of the Concept ........................ 6 B. Definition of Integration ........................... 7 C. Types of Integration ................................ 13 D. Integration Schemes ................................. 16 E. Measurement of Integration .......................... 21 F. Concluding Remarks .................................. 24 Chapter 2 - Theoretical Framework ............................. 25 Introduction ........................................ 25 B. Limitations of the Study ........................... 26 C. Productivity and the Production Function ........... 27 D. Translog Production Function ....................... 30 E. The Regression Model ............................... 35 F. Data Considerations ................................ 40 Chapter 3 - Capital Surplus in Libya ......................... 43 A. Introduction ....................................... 43 B. Capital Surplus .................................... 44 C. Absorptive Capacity ................................ 49 D. Limited Absorptive Capacity ........................ 51 E. Labor Shortages .................................... 57 F. Industry ........................................... 60 1. Chapter 4 A. B. Ice-11:11:: Chapter 5 IDWMUCW 1. Chapter 6 A. B. Agriculture ......................................... 64 Implications for Investment: The International Alternative ....................... 66 Summary ............................................. 70 - Labor Surplus in Egypt ............................ 71 Introduction ........................................ 71 Papulation Growth ................................... 71 The Measurement of Variation in Expenditure Standards in Both Rural and Urban Areas ............. 74 Labor Surplus ....................................... 80 Growth of the Egyptian Labor Force .................. 82 Labor Force Participation Rates ..................... B3 Unemployment ........................................ 86 Surplus Labor in Agriculture ........................ 93 - Model Estimation for Egypt ........................ 102 IntrOdUCtionooo00.00.000.00oooooooooooooooooooooooo. 102 Estimates of CD Production Function for Egypt ....... 103 Productivity Measurement for Egypt .................. 107 Factor Intensity in Egypt ........................... 118 Elasticity of Substitution .......................... 121 Policy Implication of Resource Allocation ........... 126 Allocative Efficiency ............................... 128 Optimum Level of Egyptian Labor ..................... 134 Summary ...... ........ ......................... ..... 136 - Model Estimation for Libya ........................ 138 Introduction ........................................ 138 Estimates of CD Production Function ................. 138 ii C. Human Capital ................ . ....................... 142 0. Productivity Measurement for Libya ................... 143 5- Factor Intensity ........... . ......................... 150 F. Estimation of AES Between Capital and Labor in Libya ....................................... 152 G. AES and Income Share ................................. 154 H. Policy Implications of Resource Allocation ........... 155 I. Summary .............. . .............................. . 158 Chapter 7 - The Integrated Economy ............................. 159 A. Introduction ......................................... 159 B The Pooled Production Function ....................... 159 C. Estimation of the Pooled Regression .................. 162 0 Estimation of AES Between Capital and Labor in the Integrated Economy ............................ 164 E. Productivity Measurements ............................ 166 F. The Efficient Allocation of Resources ................ 169 G. The Production Possibility Frontier for the Integrated Economy.. .................. . ......... ..... 175 Chapter 8 - Conclusions ........................................ 183 Bibliography ................................................... 191 Appendix A ........................ . ........................... 197 Appendix B ..... . ........... . .................................. 205 Appendix C . ................................................... 207 Appendix D .................................................... 208 iv LIST OF FIGURES Figure Page 1-1 Partial Equilibrium Diagram ............................ 15 4-1 Lorenz Curves for Rural and Urban Household Expenditure, 1958-59 to 1974-75 ........................ 77 4-2 Lorenz Curves for Rural and Urban Income Distribution 1975-75 ................................... 79 7-1 Allocation of Resources in Egypt and Libya ............. 172 7-2 The Production Possibility Frontiers of the Integrated Economy ..................................... 182 LIST OF TABLES Page Net External Transactions: Total Economy .............. 45 Net External Transactions: Non-Oil Sectors ............ 46 International Reserves (In Millions of Dollars) ........ 48 Population, GDP Shares, and Oil Exports of Libya and Other Producing Countries .................... 52 Oil Revenue and Actual Development Expenditure (1971-1978) ............................................ 54 Estimated Incremental Capital Output Ratio For Six Sectors from 1971-1978 ......................... 56 Population Estimates for Total and Libyan Nationals for the Years 1966-1977 ...................... 58 Estimated Total Population and Libyan National and Labor Force for 1965-1977 ................. 58 Educational Levels of the Total Labor Force in 1977 .......................................... 50 Value Added and Gross Fixed Capital Formation 1964-1978 .................................... 63 Value Added, Gross Fixed Capital Formation and Subsidies: The Agriculture Sector 1962-1971 ....... 65 PopuIation Growth in Egypt ............................. 72 Births, Deaths, and Rates of Natural Increase of Population, 1950-54 to 1975 ......................... 73 Size Distribution of Household Consumption Expenditure in Urban Egypt ............................. 76 Distribution of Rural Household Consumption Expenditure, 1958/59, 1964/65, and 1974/75 ............. 76 Growth of the Egyptian Labor Force ..................... 83 Age Structure of the Population ........................ 84 Table 4- 7 4- 8 4- 9 4-10 4-11 4-12 4-13 4-14 4-15 4-16 vi Page Crude Activity Rates of Urban and Rural Areas .......... 85 Employment and Unemployment Rates ...................... 87 Employment by Economic Activity ........................ 91 Employment by Economic Activity ........................ 92 Value of Agricultural Production, Costs of Inputs and Value Added in Current Prices in Millions of Egyptian Pounds ......................... 94 Number of Working Days in Agriculture - 1976 ........... 95 Distribution of GDP by Economic Activities ............. 97 Civilian Employment by Economic Activity ............... 97 Marginal Productivities for Selected Years ............. 98 Comparison Between Agricultural and Industrial Wage Rates ............................................. 99 Wages and Productivity in Agriculture .................. 101 Changes in Real Product, Factor Cost, and Productivity 1965-1977 ............................. 110 Estimates of Marginal Productivities of Capital and Labor for Egypt ............................ 113 Estimates of Marginal Productivities of Capital and Labor for Egypt ............................ 114 Capital-Labor Ratio of Egyptian Labor in S ............. 115 Estimates of MRS K for L in $ .......................... 119 Estimates of AES for the Egyptian Economy .............. 124 Average Wage in Three Major Sectors .................... 131 Efficiency Index of the Three Major Sectors ............ 132 Employment and Productivity in Agriculture and Manufacture ........................................ 133 Estimate of the Labor Surplus in the Egyptian Economy ................................................ 135 Page Estimates of Marginal Productivity of Capital and Labor for Libya ............................ 144 Estimates of Marginal Productivities of Capital and Labor for Libya ............................ 145 Capital-Labor Ratio in the Libyan Economy .............. 147 Estimates of Labor Productivites Per Man Workday in Three Sectors ............................... 149 MRS of Capital for Labor-Estimates in $ ................ 151 Estimates of the AES for the Libyan Economy ............ 154 MPL and MPK for Egypt Under Second Scenario, Assuming Two Billion Dollars are Transferred to Egypt.. 167 MPL and MPK for Libya under Second Scenario, Assuming Two Million Workers are Transferred to Libya.. 168 The Estimated Values for 0E and QL in Million $ ........ 180 Introduction This study is an attempt to investigate the possibility of econo- mic integration between Libya and Egypt. The importance of this study stems first from the high priority attached to the goal of economic development as stated in the development plans of both countries. Their experience indicates that the goals set forth have not been achieved, at least at the desirable rate. Second, both countries are of small economic size, particularly Libya. The limited size of the domestic market tends to place a more severe constraint on development after the initial phases of "easy-import substitution" is completed. Third, the two economies are faced with basic structural "deficien- cies" in their initial factor endowments. Specifically, Libya enjoys a large surplus of financial capital which cannot be absorbed domes- tically due to many constraints, of which the most important is the scarcity of skilled and unskilled labor. By contrast, there exists in the Egyptian economy a widespread labor redundancy coupled with acute shortage of capital. To the extent that economic integration through the mobility of factors of production offers advantages in terms of economies of scale and external economies, by virtue of increasing the effective size of the integrated market, it may accelerate the process of economic devel- opment. These effects of economic integration, however, must be con- sidered in the light of fragmentation and disintegration, some of which may be derived from the process of economic integration itself. 2 The problem with which this study deals can be stated as follows: Are there viable economic reasons for integrating those two economies? And if so, through what mechanism can integration be achieved? What are the likely gains, and is it possible to estimate the magnitude of such economic gain? Our main hypothesis is that economic integration between Libya and Egypt is likely to be beneficial. This economic gain would be more likely to be due to the "dynamic effects“ rather than to the "static effects.“ Specifically, economic integration will lead to a higher level of productivity of at least some of the factors of pro- duction and a higher level of output. The objectives of this study are 1) to build a case for econo- mic integration between Egypt and Libya. This can be accomplished by demonstrating the lopsided nature of each economy and the resultant constraints. Specifically, the goal is to prove the existence of capital surplus and labor redundancy in Libya and Egypt respectively. The aim is to show, through this analysis, that integration is the most viable alternative for fostering economic development for both economies. 2) To estimate and analyze the productivity of capital and labor in each economy. The purpose of the analysis will be to test the two following hypotheses: a) that labor productivity in Egypt is "low" relative to labor productivity in Libya; and b) that the productivity of capital in Egypt is high relative to the produc- tivity of capital in Libya. 3) To demonstrate the gains from econo- mic integration in terms of higher productivity of inputs and higher level of output for the integrated economy. 3 To accomplish the objective of this study, both theoretical and empirical analysis will be employed. The performance of both economies will be evaluated for the period extending from 1962 to 1977. The choice of this period is based on the availability of data and the fact that it encompasses the "major" changes that affected both econ- omies in the past. To evaluate the technical relationship between inputs and outputs, a Cobb-Douglas production function will be esti- mated for each economy. The results will be used to estimate the productivity of capital and labor and their marginal rates of sub- stitution. The CD production function will also be used to estimate the production relationships in the integrated economy. To estimate the elasticity of substitution between inputs, a transcendental loga- rithmic (translog) function will be utilized. Its choice is based on the fact that it does not impose a priori constraints on the elasticity of substitution among factors of production. A general equilibrium approach will be adopted to evaluate the "working" of the integrated economy. How will resources be allocated "efficient- ly"? And what is the optimal choice of output for the two combined economies? This study is presented in seven chapters. Chapter I provides a critical evaluation of the literature of economic integration from the viewpoint of its relevance to LDC's. It is intended to point out the analytical and empirical limitations of the static approach in studying economic integration. Chapter 11 provides the theoretical framework of analysis for the following chapters. CD and translog production functions, and their use in deriving approximation to the relationships of substi- tution and productivity of inputs are presented. Chapter III provides an evaluation of the concept of capital sur- plus and demonstrates its magnitude in the Libyan economy. The limited absorptive capacity will be studied and various limitations and con- straints facing the domestic market will be explored. Chapter IV examines the Egyptian labor force, its growth and par- ticipation rates, unemployment, and finally, the labor surplus in agri- culture. In Chapter V, estimates of CD for Egypt are presented. The esti- mates are used for calculating input productivities and their marginal rates of substitution. The results are used to test the hypothesis of low labor productivity. Assuming the prevailing production techno- logy is the same across Egypt, estimates of elasticities of substi- tution among inputs are presented. The results are used to estimate the impact of resource allocation both from and to Libya. Finally, the allocative efficiency of Egyptian labor is evaluated. In Chapter VI, estimates of CD for Libya are presented. The esti- mates are used for calculating input productivities and their marginal rates of substitution. The results are used to test the hypothesis of low productivity of capital. Assuming the prevailing technology is the same across Libya, estimates of elasticities of substitution among inputs are presented. The results are used to evaluate the im- pact of resource transfer both from and to Egypt. Chapter VII provides the results of the pooled production func- tion for Egypt and Libya. The hypothesis of higher levels of produc- 5 tivities within the integrated economy is tested. The gains from inte- gration are evaluated in terms of efficient allocation of resources and higher levels of output. Chapter 1 Critical Review of the Literature The literature on economic integration is a vast one. Fields such as trade, development, and economic theory are replete with reference to the term "economic integration," but there seems to be little agreement among the users of the term as to just what it means. In this chapter, I shall trace the evolution of the concept, present the various definitions it is given in the literature, and explore the different types of integration involved. I will also consider the issues pertaining to the measurement of integration. A. The Evolution of the Concept The word "integration," taken from the Latin INTEGRATIO, was mostly used in the sense of "renovation." The Oxford English Dic- tionary gives 1620 as the date for the first use in print of this word, in the sense of "combining parts into a whole." Fritz Mach- lup discloses that the term "integration" in its new economic mean- ing (Machlup, 1971) made its appearance between 1939 and 1942. Machlup traces the origin of the term and relates it to as far back as the days of Adam Smith, Sir William Petty, David Ricardo, and In Economics, the word was first employed in industrial organi- zation to refer to combinations of business firms through agreements, cartels, concerns, trusts, and mergers. In the sense of combining separate economies into large economic regions, the word “integra- tion" has a very short history. 7 others. The early writers were expounding the advantages of extend- ing the area of free trade during the period 1690-1879. The term evolved more in the theory of international trade by writers such as Chalres Bastable, Frank Graham, and Francis Y. Edgeworth. The litera- ture during that period centered around issues such as the impact of factor prices and incomes on factor endonents and mobility. However, it was not until World War II and later that economic integration as a subject of interest developed. This was because after the war several plans for regional economic integration and even worldwide integration materialized. B. Definition of Integration Myrdal regards integration as a social and economic process that destroys barriers (social and economic) between the participants of economic activities within as well as between nations. Myrdal writes, "The economy is not integrated unless all avenues are open toeverybody and the remunerations paid for productive services are equal, regard- less of racial, social and cultural differences" (Myrdal, 1956, p. 11). Most economists, however, consider only international aspects of economic integration, including the relevant aspects of international cooperation. Professor Triffin, for example, considers the activities of OECD (The Organization for European Cooperation and Development)and EPU (The European Payments Union) as forms of economic integration (Trif- fin, 1956, p. 618). A somewhat more restricted definition is given, along similar lines, by F. Hartog, who defines integration as a "rather advanced type of cooperation, as distinct from the term 'harmonization,‘ which refers to mutual consultation on important issues of economic policy" (Hartog, 1953, p. 165). Essentially the same interpretation is furnished by Robert Marjolin who maintains that "any process which brings about a greater degree of unity" can rightly be called inte- gration (Marjolin, 1953, p. 165). Professor Tinbergen considers inte- gration as "the creation of the most desirable structure of inter- national economy removing artificial hindrances to the optimal Opera- tion and introducing deliberately all desirable elements of coordina- tion or unification" (Tinbergen, 1954, p. 95). This concept of opti- mization introduced by him later became the basis for measurement of integration. Kindleberger and Myrdal point to the importance of social factors in destroying barriers between communities, races, and social strata. Social integration and the concomitant equalization of factor prices are necessary for total integration. Yet the removal of trade bar- riers in the case of customs unions, for example, constitutes an act of economic integration even in the absence of developments in the social field. Bel Balassa (1961, p. 63) further claims: Although social integration gains in importance as the unification of national economies proceeds, it is not necessary for the lower forms of economic integration, and it need not be included in our definition. ‘ Leaving the social factors out of the definition of economic integra- tion later proved to be one of the central elements that hindered economic integration, especially in LDC's. Balassa agrees with the objections that have been raised regarding the inclusion of national integration in the concept. Those objections rested on the ground that in the present day world, the problems relating to integration on the national and international level differ to a considerable de- gree. In the former case, the barriers between economic units are mainly of a social,educational or psychological character, and these obstacles may be stronger between various social strata of the same region than between regions. One of the main instruments of national economic integration appears to be the creation of a strong national state. However, as Myrdal emphasized, the creation of a national state leads to artifi- cial barriers between independent economies in the form of tariffs, quantitative trade and exchange restrictions, and impediments to the mobility of labor, capital, and entrepreneurs (Myrdal, 1956, p. 57). Furthermore, national economic policies, fiscal, social and monetary, represent another form of discrimination between economic units of in- dependent countries. An offset is provided by international integra- tion which leads to the elimination of some of the native aspects of national integration. In view of this, Balassa excludes national integration from the concept and defines economic integration as "a process and state of affairs.“ He writes (Balassa, 1961, p. 4): Regarded as a process, it encompasses various measures abolishing discrimination between economic units belonging to different national states: viewed as a state of affairs, it can be represented by the absence of various forms of discrimination between national economies. Machlup points out that users are virtually unanimous on the question that integration can be understood either as a process or as a state 10 of affairs reached by that process. Whether that state has to be a terminal point or an intermediate point in the process is not always clear (Machlup, 1971, p. 5), but this ambiguity can be taken care of by distinguishing between complete and incomplete integration. More difficult is the question of what is to be integrated--people, areas, markets, or policies? The most important questions thus asked are: (1) what is the substance, what are the essential features of such integration; and (2) by what indications can one decide whether there is a satisfactory process at work or a satisfactory outcome? Users of the term may agree on what the substance is and yet disagree on how one can ascertain progress. Conversely, there might be agreement on possible indicators but no agreement on the essen- tials. Machlup gives the following example: there is fundamental disagreement on the relation between economic integration and equal- ization of incomes (or of the prices of productive services) in dif- ferent areas. (Some writers regard equalization as the essence of integration; others, as the main target; others as an indicator; and others as merely incidental or even unrelated to economic integra- tion). Balassa wants his previous definition to be restricted to the state of affairs of different nations joining in a regional group or bloc. One can question this restriction as unnecessary and unecono- mical as well because the economics of the matter is the same whether it is different provinces of a state that become "more integrated," or different nations within a bloc or different blocs in the world as a whole. One can easily differentiate by speaking of national (inter- 11 provincial), regional (multinational), and worldwide (global, univer- sal) integration (Machlup, 1971, p. 65). Furthermore, one can speak of sectoral, as distinguished from general, integration when dealing with arrangements for coordination or unified management of particu- lar sectors of two or more economies. A More recently, Balassa proposed that integration progresses through 1. freeing of barriers to trade (trade integration); 2. the liberalization of factor movements (factor integra- tion); 3. the harmonization of national economic policies (policy integration); or 4. complete unification of these policies (total integration). This demarcation of issues does not resolve the underlying issues, of course. To what extent does factor integration presuppose trade and factor integration? Also, does factor integration refer to all types of factors of production, and to what extent is this assumed to coexist with unrestricted movement of goods? It may be better to refer more specifically to integrated product, labor, and capital markets (Vajda, 1971). Present day market economies are characterized by a consider- abIe degree of state intervention. This renders 311 the previous definitions vulnerable as they derive from classical laissez-faire doctrines rather than present day markets and apply even less to developing and socialist countries. Pinder emphasized policy coordination which he views as an 12 important element of integration. He proposed to define economic in- tegration as "both the removal of discrimination as between the econ- omic agents of the member countries and the formation and application of coordinated and common policies on a sufficient scale to ensure that major economic and welfare objectives are fulfilled" (Pinder, 1968, pp. 88-110). The Hungarian economist Irma Vajda, while emphasizing the need for policy coordination, criticized the definition put forward by Pinder as too general. Vajda introduced the distinction between "market integration" and production and development integration. He defined "market integration" as "the guarantee of unhindered sale of each other's product within the framework of the social system of participating countries" (Vajda, 1971, p. 35). He defined the sec- ond as "raising to an international level of programming the produc- tion of those branches of industry which cannot be developed to an optimum size within national boundaries." Vajda thus distinguishes between trade integration through the removal of barriers of trade and integration through industrial programming on the regional (plur- inational) level. This distinction is applicable to developed mar- kets as well as to socialist, and to developing economies as well. This review reveals a tendency to focus on economic integration 1. as it refers to the division of labor, 2. as it involves the mobility of goods or factors, or both, and 3. as it relates to discrimination or nondiscrimination in the treatment of goods and factors. 13 But it is difficult to find a definition of integration that applies to all types of economies. This difficulty, in my view, stems from a fundamentally wrong approach to the problem; namely, the tendency to separate the objectives of integration from the tools which are likely to be the most appropriate and effective in achieving them. The fail- ure to realize this has led to more serious problems. The most seri- ous is the omission of the differences that exist between different countries, in particular the differences between DC's and LDC's. C. Types of Integration Balassa summarized the various stages of economic cooperation and integration as follows: 1. Free trade area where particpating countries abolish tar- iffs and quantitative restrictions on trade in local products between themselves, but each country retains its own tariff against non-mem- bers. 2. The customs unions which, in addition to free trade be- tween members, includes imposition of the same external tariffs against non-members. 3. The common market, which is a more advanced stage of inte- gration where restrictions on factor movements within the area are also abolished. 4. The supranational union, the most advanced form of integra- tion, where the governments of participating countries relinquish their sovereignty over economic and social policies to a suprana- tional authority (Balassa, 1961, pp. 1-2). Following the classical theory of international trade, it was assumed that a customs union 14 will always raise world welfare because it means a free trade area without any restrictions. Viner, however, demonstrated that this was not always the case by introducing the concepts of trade creation and trade diversion (Viner, 1950, p. 44). This can be shown as follows: consider a three country world in which countries A and 8 form a customs union which means country C will be subject to a common external tariff. This action has three effects. First, with respect to products in which A and B are competitive, the elimination of tariffs between them causes the replacement of some high-cost production by imports from the partner country. This effect, known as Imade creation, is favorable to world welfare since it ra- tionally reorganizes production within the union. Second, for products in which country C is competitive with one of the integrating countries, A or 8 begins to import from the other what it earlier imported from C. If C is the most efficient producer it would be the major supplier for as long as its product received the same tariff treatment as those of its competitor. But the tar- iff discrimination induces diversion of trade away from C toward a member country. This effect, known as trade diversion (Kreinin, 1975, p. 309), is unfavorable because it reorganizes world produc- tion less efficiently. Production shifts from the most efficient location in C to less efficient ones inside the union. Finally, there is a favorable consumption effect, as consumers in each member state benefit from price reduction on imports from the partner country when intraunion tariffs are removed. Indeed, 15 Professor Kreinin argues that a net unfavorable production effect (when trade diversion exceeds creation) may be more than offset by the consumption effect, yielding a net gain in welfare. These three effects can be illustrated with the help of a partial equilibrium diagram. FIGURE 1-1 P ‘r PARTIAL EQUILIBRIUM DIAGRAM S t P3 T b P2 . B / r q \ \ P1 / T\ D 0 Q op1 = price under free trade 0p2 = price of customs union plp2 = tariff of the customs union on C products tT = trade diversion br = trade creation qB = consumption effect Those effects constitute "static effects." "Dynamic effects," on the other hand, represent the expansion of the market size which enhances the production on a large scale. Furthermore, these effects concen- 16 trate on growth and development considerations. Unfortunately, the literature has little to give concerning these issues of dynamic ef- fects. 0. Integration Schemes 1. Integration in developed countries The EEC (European Economic Community) is by far the most devel- oped scheme of economic integration in developed market economies. The original members of the EEC were Belgium, France, Germany, Italy, Luxembourg, and the Netherlands. The United Kingdom joined the EEC in 1974. Following the creation of the EEC, existing quantitative restrictions on intra-area trade were soon abolished, tariffs on intra-area trade reduced, and a common tariff on extra-area imports established. The volume of trade expanded dramatically following the abolishment of barriers of trade. Between 1959 and 1971, trade among original members increased sixfold, as against a fourfold in- crease in their total imports and exports. As a result, the share of intraEEC trade in the total rose from one-third in 1959 to one-half in 1971 (Balassa, 1961). Balassa raises the question, to what extent the expansion of intraEEC trade represents trade creation (the replacement of domestic by partner country source of supply) or trade diversion (the replace- ment of foreign by partner country sources) and how these changes in trade flows affect the welfare of member and nonmember countries? He estimated trade creation and trade diversion in the EEC using two techniques: first, the traditional comparison of ex-post income 17 elasticities of import demand in intra-area and extra-area trade for periods preceding and following integration; and second, using input- output techniques. Based on his estimate, he reached the conclusion that trade crea- tion exceeded trade diversion several times. Balassa further concluded that trade creation has resulted largely from intra industry speciali- zation in manufacturing which brings benefits through the exploitation of economies of scale which boosts economic growth in member countries, enabling them to attain the post-war reconstruction rates of growth. While trade diversion has occurred in the case of foodstuffs, chemicals and simple manufactured goods, it has been offset by in- creased imports of machinery and equipment, which have been associated with the expansion of investment activity and the trend toward thernnw chase of more sophisticated machinery in the EEC. The effects of the EEC on nonmember countries have been rather uneven. The main beneficiary has been the United States, which is the principal supplier of the sophisticated machinery and equipment demanded in the EEC countries. By contrast, developing and socialist countries have been adversely affected by trade diversion in food and in simple manufactured goods. In particular, the increasing barriers to food imports have penalized foreign suppliers. Finally, Balassa stresses the point that, while the beneficial effects of integration on economic growth in the common market stem from "market integration" in manufactured goods, little progress has been made with regard to "production and development integra- tion." This is seen in technologically sophisticated industries, 18 such as aircraft, space, computer and electronics, where efficiency operations are limited by the size of national markets (Balassa, 1961, p. 21). Given the still unresolved probIems of the EEC, it is necessary to harmonize a wide range of policies to achieve the goals envisaged for the community. A simple tariff removal is not sufficient. Har- monization of policies is needed in various fields, such as transport- ation, social security and monetary and fiscal policies relating to the free movement of capital and labor. The more recent develop- ments, such as the oil price increases and the advent of floating rates, have shown a great resistance on the part of member states to relinquish the vital element of national sovereignty. The EEC experience shows that further harmonization willbe perceived as in conflict with nationalistic values and considerations. 2. Integration in socialist countries. The Council for Mutual Economic Assistance (CMEA) was estab- lished in 1949. The participating countries are: the USSR, Bu]- garia, Hungary, Poland, Romania, Czechoslovakia, Albania, and the German Democratic Republic (GDP). Mongolia and Cuba recently joined while Albania has ceased participation. In 1959 these countries signed the formal charter of CMEA, which added to the original pur- pose of economic cooperation (as stated in the foundation declara- tion of 1949) the objections of speeding up economic and technical progress in (the member) countries and of industrializing the less developed countries (Article 1). The resolution on "basic" principles of International Social- 19 ist Division of Labour adopted in 1962 called for a rational division of labor within the framework of long-term agreements calling for the coordination of national plans. This would eventually include coor- dinated multilateral plans aimed at such things as the working out of consolidated economic balances, and the "future creation of a communist world economy, directed according to a uniform plan." The coordination of national plans remained one of the key objections in the comprehensive program adopted in 1971. However, the document emphasized the primacy of national planning bodies in the process of cooperation and of national interest in intra CMEA specialization and made no mention of a common plan (Shaefer, 1972). This apparent change reflects the rejection of "establishing a unified planning organ" and of the idea of planning at the CMEA level. Integration within the CMEA has a different character. Dif- ferent stages of development and different mechanisms are inherent in socialist integration. For example, the socialist countries did not make use of such methods as the establishment of customs unions or free-trade zones, since these do not have the same role as the ones in western countries. On the other hand, the existence of social ownership of the means of production allows the intro- duction of such forms of integration based on the planned develop- ment of socialist economy, and following the activity of the soc- ialist state and its economic organization (Maksimova, 1971). For that reason, integration in the CMEA started with higher and more compIex forms: coordination of economic plans, and the creation of a mechanism for scientific, technical and production cooperations. 20 The joint efforts of the participating countries then would be under- taken to tackle major problems in the energy sphere, including atomic energy. the production of raw materials, and the establishment of electronic computer systems and a number of other branches of industry and cooperation of production. During the years 1949 - 1973, the combined national income of the member countries increased eightfold and industrial production more than twelvefold (Maksimova, 1971, p. 35). The corresponding indices for the EEC Six over the same years were 3.6 times and 5.5 times, and for the EEC Nine it was threefold and fourfold respectively. Bal- assa contradicts those estimates. He writes (Balassa, 1961, p. 35): With the availability of assured market outlets, the trade of the CMEA countries has continued to grow. However, the rate of expansion has slowed down, and the share of intra-area trade has declined since the CMEA charter was signed. The average annual rate of growth of imports by CMEA countries, taken together, was 8.5 percent in the period 1959-71, as against 10.7 percent in 1953-59. The differences become larger if calculations are made in terms of constant prices and they cannot be fully accounted for by reference to the slowdown in the rate of economic growth. Thus, while the annual average rate of growth of the com- bined net material product of the CMEA countries fell from 10.3 percent in 1953-59 to 7.2 percent in 1959-70, the rate of growth on the volume of total imports declined from 12.3 to 8.2 percent. The CMEA member countries attach much importance to commodity and money relations, to the development of trade, to the improvement of price systems, and to monetary-financial and credit relations, while paying particular attention to the coordination of plans and joint production, scientific and technical activity. The efforts within the CMEA to exploit the advantages provided 21 by economies of scale have produced some results in terms of special- ization agreements in various industries. However, "so far only the first steps have been made in this complex and important field and the advantages of socialist division of labor have not yet been fully utilized" (Vajda, 1971, p. 54). While specialization agreements have assumed importance with regard to products such as machine tools, ball bearings and trucks, their growth has been limited by much the same factors as have restricted the expansion of intra-CMEA tradein general. The lack of direct contact among firms in CMEA countries reduces infor- mation flows, and tends to exclude some promising forms of cooperation. Thus, there are few agreements on the division of the production pro- cess through the exchange of parts, components, and accessories, or through comnon ventures by industrial firms. The realization of the CMEA objectives is hindered by the non-availability of goods according to appropriate specifications and at the desired time. Also, in the absence of scarcity prices, it is difficult to evaluate the gains from specialization. E. The Measurement of Integration Most of the techniques proposed to measure the progress of in- tegration dealt chiefly with trade. Thus most empirical assessments of the net benefits of the participant countries have been confined to the trade creation effects and have relied on the traditional Vinerian model which gave rise to these concepts in the first place. Each such attempt at quantification is thus based on measurement of the areas pointed out in figure (1) br (indicating trade creation) 22 relative to tT (representing trade diversion). The first step is to use a fully specified structural model of domestic and international trade. Such calculations may be made ex 3333, the appropriate position for decision making, or ex pggt. Ex 3333 estimates are those that rely solely on the sort ofia .grigri knowledge that a planner might command before integration commenced. The accuracy of ex agtg forecasts of trade effects de- pend on the reliability of the price elasticities that are used. In addition to this general problem, a key issue is whether the effect of a tariff is the same as that of an equivalent price change. The thorough investigations by Kreinin (1961) and Krause (1962) have established the fact that tariff elasticities substantially exceed the usual import-demand elasticities. Ex pggt estimates are based on some form of analysis of the historical experience of integration. The effect of integration is computed by comparing actual trade to a model that is constructed by projecting trade flows on the assumption that no integration would take place. All studies use the familiar assumption that market shares tend to be rather stable in the absence of integration. This assumption makes this approach inapplicable to LDC's. They also use the common sense idea that the validity of this assumption can be increased by disaggregating markets by products. Perhaps the chief goal of studies of integration is to discover whether there has been trade creation. This can be verified only by observing trade matrices that cover both domestic and foreign sales (Harik, 1978, p. 16). Bal- assa's method is much simpler and more operational for estimating trade 23 creation, trade diversion, and welfare (consumption) gains. His method consisted of two simple steps: (1) to compute income elasticities of demand for ultra-union and extra-union and total imports between the preunion and postunion periods; and (2) to convert the increase in the income elasticity of demand for total imports (thereby representing net trade creation) into national income terms by multiplying by the assumed efficiency gain implied by a one percent increase in im- ports relative to national income. Balassa's approach would seem valid and unbiased only as a mea- sure of what it was specifically designed to measure: trade creation in the fairly narrow Vinerian sense. It would seem, however, to re- present neither a satisfactory method of measuring total trade crea- tion (including the growth-induced effects on imports) nor a method of capturing the total effects of customs union participation, as some practitioners would like it to be (Nugent, 1974, p. 35). Nugent says since any new industry that became located within the region after the formation of a customs union would be identified as an example of trade diversion, both the Balassa and Viner methods would have the effect of underestimating net trade creation in the broader sense. Each of the above approaches to assessment of CU's has been limited to their impact on trade directly. As has already been mentioned, the effects of CU's on efficiency, income, growth, etc., which affect trade only more indirectly have been treated less frequently. On most of these effects, progress in measuring has been very limited. 24 F. Concluding Remarks Most of the theoretical work regarding economic integration has dealt with integration among developed countries in Western and Eastern Europe. The main concern was over the welfare effects of integration as discussed by Viner in terms of trade creation and trade diversion. In order to discuss integration as it relates to developing countries one has to focus on different issues. LDC's objectives in economic integration are to accelerate industrial development and to foster economic growth. Therefore, one has to discuss the effects of inte- gration on factors of production in terms of availability and mobil- ity. One problem that is associated with integration is the concen- tration of factors of production in high-growth areas which might lead to increasing economic disparity among regions. Some positive effects of integration had to do with improving specialization, thus avoiding the inefficiency that might be caused by duplication. Specialization could be either inter- or intra-industry. The economies of scale argument has also been advanced as an argument for integration among LDC's. The argument is that in order to construct "efficient" size plants one has to have an extensive market that would not be optimal for any single country and the alternative is to join the various small markets into one large market that will justify the construc- tion of large-size plants. Chapter 2 Theoretical Framework A. Introduction Factor integration implies the removal of discrimination between the economic agents of Libya and Egypt. This assumption is to ensure the free mobility of resources between the two economies. Further- more, factor integration requires the formation and application of coordinated and common policies within and between states on a suf- ficient scale to ensure that the major economic and welfare objectives are fulfilled, including in particular the allocation of resources in the most efficient way. The optimization of resources will require at one point in this study invoking the assumption of a competitive factor market. Although this assumption may not be realistic, the major results of this study hold as they are not necessarily based on that assumption. The assumption of similar technology in both economies is cru- cial in evaluating the way in which resources should be allocated between the two economies. Although this may be hard to accept, at least the results do not challenge the assumption. Because of the relatively small size of both economies, the effect of their union on the price level will be negligible. Henceforth we assume that prices will remain constant at least through the initial phases of the economic integration. Finally, throughout this study the social and political constraints are assumed to be 26 neutral. Next we will consider the main analytical tools that will be used in this study. B. Limitations on the Study The results of the empirical study should be taken with caution due to several limitations. First and foremost is the lack of re- quisite data and the imperfect character of such statistics as are available. In most cases, aggregate figures are available through two major sources: 1) international institutions such as the United Nations, the World Bank and the various OPEC institutions; and 2) government sources. Although the aggregate figures differ, and some- times markedly, they are generally consistent and are probably the most reliable. The approach to these figures was one of comparison, where each set of data is adjusted based on the estimates from the three primary sources. The major limitation is the lack of more detailed data. They are very hard to come by and what is available is very rarely up to date. The data on wages and unem- ployment fall into this category. The second limitation is the aggregative nature of the study. Like any macro study, the present model reduces relationships that are vastly complex in real life into compact, high aggregative eco- nomic relationships. It is impossible, therefore, to assemble at one central point all the detailed information about two vast eco- nomies. Although desirable at certain stages of the analysis, such information is not deemed necessary for the major objective of the model. It was felt that a macro model was best suited to analyze 27 the main effects of allocating labor and capital between Egypt and Libya. First to analyze the relationship between those two inputs such as their productivities, their rates of substitution, etc., within each economy separately, and secondly, within the integrated economy. Once such basic interconnections are discovered they can provide the starting point from which further and more detailed analysis can be carried out. The data limitations mean that the major thesis of this study can be only partly supported by empirical results. They rest, of course, on a sound analytical base of the effects of a union between two highly complementary economies. One must include here the ef- fects of significant variables which defy measures and which will be highly favorable, once the political constraint, treated as exo- genous, is rendered obsolete with the formation of the union. On the whole, however, the data do not contradict the major theses of this study, the exceptions being minor and not damaging to the argu- ments put forward. C. Productivity and the Production Function Productivity is generally used to denote a relationship be- tween output and the associated inputs used in the production pro- cess. In this chapter, we are concerned with the marginal and average productivity concepts used in static equilibrium theory. We are also concerned with the relationship between outputs and inputs, in real terms, over time in a dynamic economy. The basic objectives of productivity estimates are: 28 1) Obtaining estimates of input productivity. This helps in assessing the performance of Egyptian labor and capital. 2) Obtaining at least rough measures of the impact on produc- tion of more investment, improved technology, and similar productivity enhancing variables. We now consider the notion of production function, which is the organizing principal behind measurement of the productivity relation- ship. The general form of the production function may be expressed as follows: Q= f(X1,X2, ..... xn) (T) 2.1 Q designates the potential or actual physical volume of output. Out- put may be defined in various ways; the important thing is that, given the output definition, the associated inputs (X) on the right-hand side be defined and measured consistently. In this study we gener- ally take inputs to represent the real potential or actual services of the basic factors of production. Measures of factor service in- put are consistent with measures of net output, or "value added." The factor inputs may be defined broadly or narrowly. Broadly, they may include the services of tangible as well as intangible re- sources, i.e. the stock of productive knowledge incorporated in the labor force and in nonhuman instruments of production, or "disem- bodied" as in the organization of production. Or they may be taken to include only the tangible factor inputs unadjusted for changes in knowledge and other factors affecting efficiency. It is the latter approach which is used in this study. The tangible inputs themselves may be measured in terms of various types of labor and 29 nonhuman capital services, or they may be collapsed into the two broad factor classes of labor (L) and capital (K). Since we will use a two-factor approach, the production function can be narrowed to: Q = f(L,K) (T) 2.2 The variable, T, sometimes loosely called "technology," really com- bines all other factors which affect output apart from the physical volume of the tangible factor inputs. It is less misleading to refer to T as the "productive efficiency" of the tangible factors. Since the intangible capital stock accumulated through investments in re- search and development, engineering, education and training, and so on, is the chief element behind such productive efficiency, one would expect T to show much less change if such intangible inputs were in- corporated in the tangible inputs. Cobb-Douglas production function can be expressed as follows: Qt = At it gt 2.3 a and B are the elasticities of output with respect to labor and capital, and At is the level of productive efficiency in year t. The CD function becomes linear in the logarithms, hence log Qt = log A1: + alog Lt + Blog Kt 2.4 The marginal productivity of the factors of production indicate the returns that might be expected, on the average, from the addition of various resources. The marginal physical product of a given input, then, is the partial derivative of the output with respect to that input, all other inputs held constant. 30 aQt . Lt _ Qt . Lt XQtLt = ‘31:: “Q: (0’- 1?) a: a 2.5 Therefore in the Cobb-Douglas function, the elasticities of produc- tion are given directly by the respective input exponents and they are constant over the entire input-output curve. Under the conditions of perfect markets, the optimum allocation of resources is achieved when the marginal productivity of each factor is equal to its opportunity cost (Nicholson, 1972, p. 337). 30 0 w SEE' _ ‘”E£ = ._E 2.6 t P where Wt is the money wage factor of i, and p is the price of the pro- duct. Then, in order to detect the degree of efficiency in the alloca- tion of resources, we can directly compare the marginal productivity of a factor to its opportunity cost. If the ratio of marginal pro- ductivity of a factor to its opportunity cost is less than one, too much of the given resource is being used. If the ratio of marginal productivity to opportunity cost is more than one, too little of the given factor is being used. Maximum efficiency occurs when marginal productivity of a factor is equal to its productivity cost. 0. Translog Production Function The transcendental logarithmic function which was suggested by Christensen, Jorgenson and Lau (1970) represents a useful generali- zation by comparison with Cobb-Douglas and the’ordinary constant elasticity of substitution (CES) production function in that one may analyze and estimate under fairly general conditions the partial 31 elasticities of substitution among all pairs of the n>2 inputs. The CD form restricts all such elasticities to unity and the multifactor CES form is undesirably restrictive either because of the need to specify a priori certain input separability conditions or because of the a priori requirement that substitution elastici- ties stand in fixed ratios to one another. A translog production function describing the relation between physical output and input services from two productive factors may be written ln 0 = q(1nX 1nX2) 2.7 19 where X1 physical capital X2 = labor The specific form of translog 2 2 2 ant = 1nao + 2 ai 1n Xi + z 2 ln Xi ln Xj 2.8 i=1 i=1 j=1 ant = lnao + allnX1 + a2 lnX2 + 1/2 (bnlnxllnx1 + blzlnxllnx2 . + bZIInXZlnXl + b22lnX2lnX2) 2.9 a0 = the constant term representing the state of techno- logical knowledge a.b.. = the coefficients representing the technologically determined production parameter Assumption for Equation 2.8. 1. If one disregards the log-quadratic terms, 2.8 is simply a one-input Cobb-Douglas function in which a1 is strictly positive 32 output elasticity of the ith input. Yet if one or more bij is non- zero, 2.8 is distinctly different from the Cobb-Douglas form. 2. Note also that all input levels must be strictly positive, since if lnXi or lan ---> w, output becomes ill defined. 3. The production function 2.9 is linear homogeneous or sub- ject to constant returns to scale. The following parameter restric- tions pertain: i) 2 a. = 1 i -‘ M U. uni. {—1. H 0 ii) . M 0' II 0 iii) iv) 2 z b.. = o 2.10 i 4. The symmetry restriction bij ‘ bji i, j = 1, ...... ,n 5. Output elasticities must be positive. These elasticities are in general not constant but depend on the levels of input ser- vices. Thus the output elasticity for i, 2i, can be derived from the partial logarithmic derivative as 2i = (aant/alnxi) = (aQt/axi)(Xi/Qt) = fi°(Xi/Qt) 2.11 and also 2 2i = (aant/alnxi) = a1 + jil bij lan 2.12 with the assumption that input and product market are competitive (the relaxation of this assumption will be considered later on), the necessary condition for efficient production. 33 f. =P, 2.13 where Pi is the price of the ith factor service for each input. The assumption of constant prices facilitates the normalization of the previous condition; i.e. where 1 is the price of output. Therefore, the marginal product of Xi’ f1, is 2 fi = (Qt/xi)(ai = 2 bijlnxj) 2.14 1'1 the direct second-order derivative for Xi 2 _ 2 fii - (Qt/Xi )[bii + (ai + iil bijlnxj'l) 2 (ai + -E bijlnxj)] 2.15 j-1 the cross partial derivative with respect to Xk is k fki=(Qt/xkxi)[bki + (ak + 1:1 bkj1an) k (ai + z i=1 where i,j,k, = 1,....,n bijlan)] 2.16 From 2.14, it is clear that the translog production function allows the possibility of processing uneconomic regions over certain ranges of input space which causes fi 0 and bij> 0 2) as Xj increases indefinitely and bij<0 i,j = 1,....,n 34 Substituting 2.13 into 2.11 yields the necessary conditions for economic efficiency with reference to the distributive shares: Si = Pixi/Qt O i = 1,2 2.17 where, given the assumption of first degree homogeneity in production, Euler's theorem demonstrates that Si is the relative cost share of the ith input in the total cost of all inputs used to produce 0, i.e. 51' Pixi/ijj for any input Xi 2.18 01" 2 By estimating equation 2.19, this will yield the estimated values of the production function parameters in 2.9, which in turn will allow us to compute the values of f1, fii’ and fki respectively. The above translog production function gives us the knowledge to identify the relationship between any two inputs, i and j, wheth- er they are substitutes or complementary. Allen partial elasticity of substitution (AES) oij, measures the effect on the quantity of factor i due to a change in the price of factor j holding output and other input prices constant. Then: * o..>0 if i and j are substitutes in production 13 * Oij<0 if i and j are complementary in production * Pixi/Qt>0 is the condition needed for the function to be well be- haved, i.e. globally convex. 2 _ where 35 IF) = is the determinant of the bordered hessian matrix 0 f1 f2 f1 f11 f12 f2 f21 f22 and )Fijl is the cofactor of the i,j element, fij’ of IF). E. The Regression Model We estimate the parameters of 2.9 using stochastic versions of equations 2.19. Substituting the distributive share of each input for its output elasticity, the system of cost share equations for this translog production function can be written as follows: The equality of relative shares and corresponding output elastici- ties is established by profit-maximizing behavior in competitive markets. But introducing the disturbance terms into the stochastic versions of 2.21, 2.22 will allow the model to deviate from the purely competitive market. This relaxation may be attributed to a variety of forces, including imperfectly competitive markets. This is in effect a more realistic case for the discussion of Libya and Egypt, as we shall see later on. With the imposition of the linear homogeneity restrictions, the system of n equations of the above type become a singular sys- tem (Grant, 1979, p. 8). A non-singular set of share equations can, 36 however, be constructed by expressing the parameter of the nth equa- tion in terms of the remaining n-1 equations, i.e. 'l 'I S. a. + g bij]n(xi/Xn) + n1 2.23 where n = 1,2,j(i,j # n) = 1,2 Thus, if we choose to estimate equation 2.21, the set of factor share equation would appear as follows: S1 = a1 + bllln(X1/X2) 2.24 From the estimated parameter of the two equations, 2.21 and 2.2, using version 2.24 together with the assumption of linear homogeneity and the symmetry restrictions, we will be able to identify exactly all parameters of the production function 2.9. The remaining parameters are determined from the linear homogen- eous constraints 1) a1 + a2 = 1 2) D21 = ‘b11 3) 612 + 622 = 0 Similar procedures will yield a share equation: S2 = a2 + b121n(X1/X2) 2.25 For each system of the share equations, the disturbances are likely to be correlated across equations. Thus for any i and j, "i is likely to be correlated with uj. This suggests that Zellner's (1963) two stage estimation will yield efficient parameter estimates. However, the estimators obtained by Zef estimation depend on 37 which equation in the system equation 2.21, 2.22 is chosen. Maxi- mum likelihood estimates would, of course, be independent of which equations were selected. Kementa and Gilbert (1968) demonstrated in a series of Monte Carlo experiments that maximum likelihood (ML) and Iterated Zellner efficient estimation (IZEF) lead to identical estimates in all samples. From the estimated parameters a. and bij’ we can calculate the 'I value of the first derivative, f1, and second derivative, fij' tions 2.14, 2.15, and 2.16 indicate that the values of the fi and f1 Equa- j’ and therefore the numerical values of IF) and lFijl’ generally vary with the levels of input usage. Therefore, we will present point estimates of the partial elasticities evaluated at the sample means. Using equation 2.19, the mean value of the relative cost shares of each input will be 2 * 1: . = S1 = a1 + iil bijlnxj for J 1,2 where the starred variables refer to sample means. Then the first and second derivatives with respect to the other inputs evaluated at sample means will be * * * .* f1 ‘ (Qt/x1) S1 * ** .* f1 = (Q/Xl) s1 ** f2 = (Q/xz).52 ”- -*** ** f12 ‘ (Q/Xlxz) (”12 T 5152) 38 The determinant of the bordered Hessian matrix will be * IF'I = 0 f1 f2 f2 f11 f12 f2 f21 f22 * Fij is the cofactor of the i, jth element of )F*) i.e. |F3j*l = (-1)(I+J) lMijl * where lMijl is the minor of the element fij (the element at the inter- section of the deleted row and column) and is obtained by deleting the ith row and jth column of the determinant of the bordered Hessian matrix )F*|. For example, 0 f * 1 2 _ 12 (‘1)( + ) ' IF f2 f The Allen partial elasticity of substitution (AES) between capital and labor will be * -(ziI/I£10 b. The concavity condition requires that the Hessian matrix of partial second derivations be negative semi-definite or (lHl<0). We can check this condition using HI = f 11 12 f 22 21 2. Model estimation First, the disturbances in each system of the share equation are likely to be correlated across equations within the system. For this reason IZEF estimation method will be employed as indicated by the earlier discussion. Second, one of the constraints of the translog production func- tion is the symmetry restriction. In general, one cannot estimate a set of unique parameters under the symmetry constraint because for any equation of the system,the estimates bij and bij(ifj) will not generally be equal when least squares is applied to each equation individually. Fortunately, the IZEF estimation method is capable of handling this symmetry restriction. Hence, the symnetry restric- tion will be taken into account in the estimation method. The estimation procedure will proceed in two different stages. 40 The first stage The purpose of this stage of the estimation procedure is to find the starting points for the parameters which will be estimated using IZEF estimation in the second stage. The estimation in the first stage is obtained by stacking the two equations into a single matrix equation in order to enforce the symmetry constraint. Each equation will be estimated by OLSQ. The second stage The purpose of the second stage is to estimate the system of the share equation by IZEF estimation. The numerical values, which are obtained from the estimation in the first stage, will be pro- vided as the starting points for respective parameters at this stage from the estimates obtained by IZEF estimation, together with the assumption of linear homogeneity and the symmetry restrictions. We will be able to identify uniquely all the remaining parameters of the production function. F. Data Considerations In light of the fact that there are no systematic and reliable data on the stock of capital in Libya, the decision was made to utilize lagged cumulativeinvestment as a proxy for capital. This procedure is adopted in several other models, and has merits in eco- nomic theory. Thus capital input will be measured as gross fixed capital formation (GFCF) adjusted for inventory and depreciation. The data for the lagged cumulative investment are available in the United Nations' Yearly Book of Statistics, and National Income 41 Accounts for Libya and Egypt. The data for inventory and depreciation are available also in the quarterly bulletin of the central banks. The year 1970 was used as a base year to generate the series of the real capital stocks for the period 1960-1979. Employment data for Libya are taken from the Population Census 1954, 1964, and 1973. The source for the distribution of labor force was International Labor Organization 1962-1978. Data on labor force and employment for Egypt are taken from the ngulation Census and Labour Force Survey 1976. The major deficiency regarding labor as an input is that it is taken as a homogeneous factor. An attempt was made to account for human capital by distinguishing between skilled and unskilled labor. The classification was made based on the distribution of labor force by occupation. However, the esti- mates thus obtained were unsatisfactory. The data on the distribu- tion of the labor force by years of education and the corresponding earnings, which obviously would make a better estimate of human capi- tal, were not available. The data for the distributive shares between labor and capital are constructed as follows. Assuming that the distributive shares of of inputs exhaust total cost (Christensen and Jorgensen, 1969, p. 24), the total costs of production at period t are apportioned be- tween the wage bill in the same period and total capital costs from the previous period. Total cost is computed by total labor costs (the wage bill) plus total capital costs. The distributive shares are calculated by dividing the cost attributable to each input by total cost (Humphrey and Moroney, 1975, p. 66). Hence 42 (Total cost)t (labor cost)t + (capital C°5t)t-1 (compensation cost)t + (income from property)t_1 and SL labor share = (labor costs)t/(total cost)t S k - capital share = (capital costs)t_1/(total cost)t The labor cost or the wage bill for each economy is determined from the labor compensation from the national income accounts. The data for the "compensation of employees" is available in the National Income Account of Egypt and the National Accounts of Libya. The capi- tal cost for each economy is measured using property income which is also available from the national income account for each country. Chapter 3 Capital Surplus in Libya A. Introduction Libya combines within the borders of one country virtually all the obstacles that can be found anywhere: geographic, economic, political, sociological and technological. It was.thought that if Libya could be brought to a stage of sustained growth, there would be hope for every country in the world (Higgins, 1968, p. 26). This is a good description for the state of the Libyan economy in the late 1940's and throughout the 1950's. When the country took its independence in 1951, the economy was in a shambles. Indeed, the prevalent view was that real development was not possible. The coun- try seemed to lack 311 major prerequisites for development. Libya had little known natural resources that could be developed. In fact, there were years (during and after World War II) when the rate of capital formation was negative. A great deal of the country's overhead capital, such as harbors, buildings, roads and water wells, was either destroyed by war or used up by total or partial depletion. Bejamin Higgins (1968, p. 26) described the situation as follows: Libya's great merit as a case study is as a proto- type of a poor country. We need not contruct ab- stract models of an economy where the bulk of the people live on a subsistence level, where per capita income is well below $50 per year, where there are no sources of power and no mineral resources, where agricultural expansion is severely limited by cli- matic condition, where capital formation is zero or less, where there is no skilled labour supply and no indigenous entrepreneurship. When Libya become an independent kingdom under United Nations 44 auspices (Dec. 1951) it fulfilled all these condi- tions. Libya is at the bottom of the range in income and resources and so provides a reference point for comparison with all other countries. Since the above was written, there has been one dramatic change: the discovery of oil and along with it the growth of oil revenues. Other constraints remain, however, indicating a limit to domestic absorp- tive capacity. In this chapter, we will examine closely the continuing import- ance of the obstacles facing the economy and the limits to domestic absorptive capacity in view of increasing oil revenues since the mid- 1960's. 8. Capital Surplus The availability of capital in large amounts in Libya is gener- ated mainly by the production of oil. The Libyan economy has been a net "lender" to the rest of the world since 1963 (the year in which oil was produced at a commercial level). Lending capital, which is a national surplus, has increased from about $824 million to $3,111 million in 1977 (Table 3-1). However, if the oil sector is excluded Libya becomes a net "borrower" from the rest of the world, as shown in Table 3-2. Two points should be noted here. First, the yearly surplus of the total economy is increasing, suggesting that the rate of in- crease in oil revenue exceeds the rate of increase in expenditure. 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Therefore, the monotonicity condition is satisfied. The Hessian matrix of partial second derivatives, I *l f11 f12 -.OOOl83 .00010 H = = f21 f22 .00010 -.000016 = -.000000008 shows that H exhibits the semi-definite sign (|H*|1, we can expect capital to be substituted for labor. The scale of substitution will tend to be low, due to the moderate increase in the price of labor and the acute shortage of capital. The decline in the labor force and the moderate rise in its prices will probably lead to a significant decline in the labor share. Meanwhile, the share of capital will increase. This reflects the fact that there are no significant changes in the relative prices of capital and labor in response to the major change in the capital- labor ratio. Finally, we can expect that the allocation of labor to Libya will result in higher productivity for the Egyptian labor force for the simple fact that capital per worker will increase. 2. The second scenario Capital transfer to Egypt (without labor transfer in the oppo- site direction), which means an increase in the capital stock, will lead to lower prices of capital. Again, the price decrease will de- pend on how much capital is transferred. The low price will increase the amount of capital in the production process through the substitu- tion of capital for labor. Recall that when o>1, this implies that the share of the factor whose price has risen (declined) will decline (increase). Thus, lower prices of Egyptian capital mean that the share of capital will increase. Finally, transfer of capital will result in increased labor productivity, probably modest relative to the gain which would occur under the first scenario. This is because 128 capital transfer is likely to take the form of assets, at least par- tially. The time lag involved in the transformation of these assets to physical capital will make the gain in productivity, at least for the immediate time, modest. 3. The third scenario A reduction in the total labor force due to labor transfer will result in a higher price of labor, as mentioned before. Because of the ease of substitution, capital will be substituted for labor, which will be manifested in the decline in the labor share. This decline will be enforced by capital transfer to Egypt, where the lower prices of capital will initiate further substitution of capi- tal for labor, thus leading to further decline in the labor share and a concomitant rise in capital share. Notice that the effect of allocating labor and capital from and to Egypt will work in the same direction of increasing the capital and decreasing the labor share. Here again, the increase in the price of labor will most likely be modest since the labor transfer effect will be at least partially mitigated by the labor surplus, which indicates that the overall decline in labor share will most likely be smaller than would be anticipated. Finally, the effect on labor productivity will most likely be significant, due primarily to the sharp increase in the capital-labor ratio. G. Allocative Efficiency An intuitive notion of efficiency refers to the achievement of maximum output from a given set of resources. The greater the output 129 relative to the inputs, the higher is the level of efficiency. The significance of examining efficiency in the Egyptian economy relates to the objective of allocating resources, that is, bidding the re- sources away from alternative uses. As a result of such resource transfers, aggregate output may be increased or decreased. The esti- mated elasticities of production indicate changes that take place in the value of output when we change the level of a given input. Would these changes increase efficient use of the factors of production? In order to answer this question, an index of efficiency must be found. It can be obtained through allocative efficiency. The traditional test for allocative efficiency (T.W. Schultz, 1960) is based on the assumption that all sectors in the economy use the same technology and that they face the same prices. It is further assumed that if the efficiency conditions exist in all sec- tors, the economy is Pareto optimal. If disequilibrium exists in the agricultural sector, then a correction through a decrease or an increase in the use of the factors may lead (but not necessar- ily) to Pareto optimality. The efficiency index is obtained by comparing the marginal product of a given resource to its oppor- tunity cost. Maximum efficiency occurs when the value of the marginal pro- duct of a resource is equal to the unit cost of that resource. If the ratio of marginal product to opportunity cost is more than one, too little of that resource is being used at a given price level. If the ratio is less than one, then too much of that resource is being used. 130 The estimate for marginal productivities is obtained from the production function. It is important to use those estimates (rather than the productivity index, for example) because within the context of the production function, the uniqueness of the isoquant is guar- anteed when it depicts the minimal combinations of inputs that can produce the unit of output. Alternatively, the isoquant shows the maximum quantity of output that can be produced with ggy combinations of inputs. As a measure of the opportunity cost of one unit of labor, we took the average wage per worker per year (as shown in Table 5-7). The index then is compiled by using the marginal productivity of labor from R1. The estimate in Table 5-8 indicates inefficient use of labor in both the distribution sector and the service sector. The commodity sector, in contrast, displays a ratio of more than one, which indicates that "not enough" labor has been employed in that sector. This conclusion, however, needs to be qualified. The commodity sector combines agriculture, manufacturing, con- struction, and electricity. Productivity per worker in the latter three is much higher than in agriculture. For example, producti- vity per worker in manufacturing averages about ten times higher than productivity per worker in agriculture (Table 5-9). This implies that manufacturing is more efficient, which is consistent with the overall efficiency index obtained for the commodity sec- tor. In comparison, agricultural productivity indicates a very low level of efficiency. Furthermore, if we take into account the fact that agriculture is the largest single employer in the economy, 131 TABLE 5-7. AVERAGE WAGE IN THREE MAJOR SECTORS Commodity Distribution Services Year Sectors Sectors Sectors 1962 127.6 322.0 461.4 1963 148.5 331.2 499.1 1964 159.6 356.5 544.4 1965 174.1 374.9 460.5 1966 187.2 391.2 483.0 1967 192.1 392.0 488.7 1968 188.6 403.6 472.1 1969 196.2 414.0 495.0 1970 201.9 423.0 519.8 1971 235.9 444.8 687.7 1972 240.8 460.3 720.4 'W, = 186.6 .Wd = 391.12 'Ws = 530.18 T = 2052.51 4313.3 5832.0 Source: National Bank of Egypt Bulletin, December 1976. 132 TABLE 5-8. EFFICIENCY INDEX OF THE THREE MAJOR SECTORS Commodity Distribution Service Year Sectors Sectors Sectors 1962 1.90 .79 .55 1963 1.83 .82 .54 1964 1.70 .80 .52 1965 1.60 .74 .60 1966 1.50 .71 .58 1967 1.40 .69 .55 1968 1.20 .56 .48 1969 1.40 .66 .55 1970 1.42 .67 .55 1971 1.20 .65 .42 1972 1.30 .63 .40 TABLE 5-9. 133 EMPLOYMENT AND PRODUCTIVITY IN AGRICULTURE AND MANUFACTURE Agriculture Manufacturing Annual Annual Average Average Year Employment Productivity Employment Productivity 1962 3,600.0 238.3 679.0 ' 1049.9 1963 3,632.0 269.3 725.9 1111.82 1964 3,730.0 297.4 789.7 1142.6 1965 3,751.0 256.96 825.0 1152.8 1966 3,877.2 359.26 841.7 1259.9 1967 3,864.6 364.3 846.7 1296.74 1968 3,892.4 380.9 367.3_ 1219.0 1969 3,964.9 399.3 890.7 1301.1 1970 4,048.3 438.16 916.1 1360.7 1971 4,056.9 438.84 1052.8 1335.2 1972 4,094.7 586.9 1094.3 1337.9 Source: National Bank onggypt Bulletin, 1976, p. 130. 134 it can be seen how inefficiency is widespread. This implies that the efficiency index obtained for the commodity sector is a rather inac- curate parameter for the actual efficiency of the sector. Finally, if we compare the marginal productivity estimated at the geometric mean with the average mean of the three sectors, the ratio is $0.76 (282.2/3696). This can be taken as a general indication of ineffi- ciency that calls for labor reallocation. H. Optimum Level of Egyptian Labor According to the marginal productivity theory, the marginal product of labor is equal to the wage rate. In a CD model, for example, we have = 9 W1 (IL 5.23 where W’ is an "average" wage rate, Q is output, L is quantity of 1 labor, and a is the labor coefficient in the production function. Given an estimate of a, we can solve for L in terms of a, Q, and 'W ginal product to the wage rate. By comparing this estimate with 1. This would give us the quantity of labor that equates the mar- the quantity of labor actually used, we can measure the extent of surplus labor. For the sample as a whole, the estimated level of labor out- put at which the marginal productivity of labor equals the postu- lated opportunity cost of $396.60 per year is 6,227,579 workers for R,, which indicates a labor surplus of 1,928,300 workers, as can be seen from Table 5-10. For R4 at the same average wage rate of 135 TABLE 5-10. ESTIMATE OF THE LABOR SURPLUS IN THE EGYPTIAN ECONOMY R, R4 Labor (man-year) 6,227,579 1,168,318 Surplus 1,928,300 6,987,800 all sectors, the estimate level of labor is only 1,686,318, which indicates a much larger labor surplus. This rather unrealistic result of the optimum level of labor points out the limitations of this kind of analysis. The optimum levels of labor estimated in R1 and R4 are sensitive to changes in the opportunity cost of labor and particularly to the size of the labor coefficient. For example, an increase in the annual average wage rate of $300 will reduce the optimum level of labor by about half a million workers. A reduction in the labor coefficient of about 10 percent (from 1.22 to 1.08) in R1 reduces the optimum level of labor by about 74 percent (from 6,287.2 to 1,562.0). The extreme sensitivity of equation 5.23 to variation in the size of the production elasticity coefficients imposes serious limitations on its use. However, it is important to observe that although the estimated levels of Egyptian labor vary widely, all estimates indicate a surplus of labor. The unsettled question is the size of that surplus. 136 1. Summary The various measurements of the aggregate production function for the Egyptian economy revealed the labor-intensive nature of the econ- omy as a whole. This conclusion was supported by the factor inten- sity analysis of capital and labor. Those estimates provided a starting point for productivity measurement of inputs. Although the measurements varied depending on the labor coefficient for each equation, they yielded the same trend of both labor and capital over time. The productivity of labor increases, then decreases, and then increases again. This behavior is consistent with the increase and decline in the capital stock. The productivity estimates tend to confirm the hypothesis of low productivity of Egyptian labor rela- tive to other LDC's and, in particular, to the productivity of Libyan labor, as will become apparent in the following chapter. The productivity of capital is somewhat higher than that of labor. Yet, the results are inconclusive when testing for the hypothesis that the rate of growth of capital productivity is higher than that of labor. The estimate of the elasticity of substitution between capital and labor indicates that it is "easy" to substitute capital for labor. However, the isoquants tend to be "flatter" than expected. The estimate was used to evaluate the impact of allocation of re- sources under three different scenarios. The analysis seems to suggest that the transfer of labor to Libya coupled with capital transfer in the opposite direction will lead to an increase in the 137 in the productivity of labor. The enhancement will be due primarily to the sharp increase in the capital-labor ratio. Furthermore, the share of capital will increase and the share of labor will most likely decrease as a result of the reallocation of resources. Finally, the analysis of allocative efficiency and the optimal level of resources shows strong evidence of inefficiency, particu- larly in the allocation of the labor force. Thus, the reallocation will most likely increase efficiency of resources, in particular labor. Chapter 6 Model Estimation for Libya A. Introduction This chapter presents the results of estimates of the CD pro- duction with two inputs, labor and capital. The translog produc- tion function estimates are also presented. The prevailing pro- duction technology is assumed to be the same across Libya. The hypotheses that need to be tested are: first, that the productivity of Libyan labor is high relative to that of Egyptian labor; and second, that the reallocation of resources to and from Libya should increase the overall productivity of both capital and labor. Among the results that will be discussed are: (1) estimates of CD production function for Libya; (2) human capital; (3) pro- ductivity measurement for Libya; (4) factor intensity; (5) elas- ticity of substitution between capital and labor; and (6) policy implications. 8. Estimates of CD Production Function A CD production function is fitted for the Libyan economy with data covering the period 1962-1977. The independent variables are labor and capital. The dependent variable is gross domestic product. The results are: log 0t = -3. 8 + 1.17 log L + .71 log K R2 = .97 6.1 (-1. 26) (1. 6) (3. 2) 139 The coefficient of capital is significant at the 5 percent sig- nificance level. It shows that a one percent increase in capital will lead to a 0.7 percent increase in output. The coefficient of labor, however, is not significant. The assumption of no technological changes (embodied in equa- tion 6.1) was abandoned, and the equation was estimated with time as an additional independent variable, T. The estimated result is: log 0t = 12.1 - 1.58 log L + .59 log K + .21 log T 6.2 (2.89) (-1.98) (4.09) (4.3) ‘32 = .99 Although the variable T is significant, which could imply that technological changes have not been neutral during 1962-1977, the labor coefficient not only is insignificant, but also carries the wrong sign. Equation 6.2 has a Durbin-Watson test of 1.65. This can indicate the existence of autocorrelation. Adjusting for this, the estimate is: log Qt = 11.9 - 1.56 log L + .57 log K + .21 log T 6.3 (2.7) (2.6) (1.2) (3.9) ‘R2 = .98 As can be seen from equation 6.3, labor still has the wrong sign. When the variable T is dropped from equation 6.3, the results are more satisfactory: log 0t = -7.3 + 1.99 log L + .48 log K '32 = .91 6.4 (-2.28) (2.7) (2.3) on = 2.1 Both coefficients are significant. Equation 6.4 shows that a one 140 percent increase in labor or capital will increase output by 1.99 or .48 percent, respectively. Notice that whenever the time trend is added to the equation, the labor coefficient becomes negative. A possible explanation is that technological change is embodied in the labor input. This possibility will be tested later. When the production function is restricted to pass through the origin, the estimated equation is: log Qt = .25 log L + .97 log K 6.5 (3.2) (14.0) Both labor and capital coefficients are highly significant when com- pared with equation 5.3. The difference between the two production functions becomes very apparent. For Egypt, the elasticity of output with respect to labor is .698, or three times that of Libya. Con- versely, the elasticity of output with respect to capital is only about one-third that of Libya. Those estimates of the coefficient reflect accurately the factor endowment of each country. An alternative formulation of the production function is to lag the adjusted gross capital formation one year and re-estimate the equation. The results are: log Qt = -5.4 + 1.72 log L + .48 log K,;_1 'R2 = .97 6.6 (2.0) (2.6) (2.4) 0W = 1.36 The results represent a good fit. When equation 6.6 is adjusted for autocorrelation, the results are: log 0t = 6.59 + 1.98 log L + .41 log K “R2 = .94 6.7 (-2.1) (2.6) (1.8) t‘1 141 The previous estimates of the production function for Libya show first, that the Libyan economy is labor intensive. This may appear strange, but not when we realize that "financial capital" abundance does not translate immediately to productive capital; that is, flow of services. The fact that Libya has to import all its capital goods introduces a time lag. More important, the shortage of skilled and unskilled labor imposes the major restriction on domestic capacity and prevents the absorption of surplus capital. Second, the Libyan economy has been experiencing increasing returns to scale during the period, which is probably due mainly to the oil sector. Returning to the concept of technological changes, the inference from equation 6.2 that such changes have been non-neutral is not a comfortable one because the equation does not represent a good fit overall. If, instead, we want to test the hypothesis that techno- logical change is embodied, that is, introduced in the variable it- self, this can be accomplished by redefining the units in which the inputs are measured. Similar to equations 5.8 and 5.10, equations 6.8 and 6.9 represent the estimates of the production function. Augmented capital is the dependent variable in 6.8, and both aug- mented capital and labor are the dependent variables in 6.9. The estimates are: ‘ Log 0 = 5.6 - 0. 43log L + 0. 58logK - 0. 000004logKU + .IST 6. 8 (0.46) (0.20)9 (3.94) (0.56) (1. 42) R2- 109 Q = 0.98 + O. 8GllogL + 0. 33logK + .000002logKu - (0.76) (0.25) (1.18) (0.82) .00003logLu + .271 ‘R‘2 = .97 6 9 (1. 07) (1. 07) ~ 142 where Ku and Lu are augmented capital and labor, respectively. The coefficients of factor augmentation are small (not different from zero) and not significant. This can be interpreted as a rejection of the hypothesis that technological changes are labor or capital augmented. As we will see later in this chapter, both the ratio of marginal productivity of capital and labor and their respective shares change over time, which--as in the case of Egypt--reinforces the notion that technology has been non-neutral throughout the per- iod under consideration. C. Human Capital To account for the change in productivity due to the change in labor quality, an attempt was made to incorporate "human capital" in the production function. The International Labor Organization (ILO) classification of the labor force by occupation was used to segregate labor into three major categories. Unskilled labor (LU) is composed of production-related workers, transport equipment Oper- ators, laborers, and workers not classifiable by occupation. Agri- cultural workers (LA) include foresters, fishermen, and hunters. Skilled labor (L5) is composed of professional and technical, mana- gerial and administrative, clerical, sales, and service workers. Agricultural workers are in a separate category because agri- culture absorbs more than 50 percent of the labor force. Thus it was thought that the distinction would be significant in identify- ing the contribution and, more important, assist in the measurement of labor redundance in that sector. 143 The results obtained were mixed and generally unsatisfactory. Below is a sample of the different formulations that have been esti- mated: log Qt = 11.07 - .138logK + .08 LU + 2.21109LS - 2.25logLA; 6.10 (.72) (.06) (1.8) (3.8) log Qt = 9.9 - .08logK - .12LU + 1.26logLS - 1.13logLA + (.52) (.52) (1.60) (1.7) .028logT; 6.11 (2.4) log 0t = 13.4 - .43logK + .062109LU + 2.8logLS + 2.8lo LA. 6.12 (5.2) (.08) (1.2) (12.6? Based on these estimates, human capital as such will not appear in the production function. 0. Productivity Measurement for Libya As was the case with Egypt, two estimates of input productivity (1 and II) were calculated for Libya using the same procedure. The results of R1, R2, RE,, and RE2 are presented in Tables 6-1 and 6-2. The rest of the estimates are deferred to AppendixEA. The estimates for marginal productivities of both labor and capital obtained from R1 are similar to those obtained from R4. Estimates from R2 are much lower, due primarily to the lower labor coefficients. Although the estimates differ, they yield the same productivity trends for both labor and capital. Those trends are, first, that in all four estimates the productivity of labor increased steadily except for a short period (1964-1970) that corresponded to the decline in the capital-labor ratio. Second, the marginal pro- TABLE 6-1. ESTIMATES OF MARGINAL PRODUCTIVITY OF CAPITAL AND LABOR FOR LIBYA 144 $ $ $ $1,000,000 Year MPL per year MPL per day MPL per hour MPK 1962 1251.22 3.56 .45 .55 1963 1391.79 3.97 .50 .56 1964 1734.63 4.94 .61 .50 1965 2189.25 6.24 .78 .44 1966 2564.54 7.31 .91 .43 1967 2812.42 8.01 1.00 .44 1968 3380.48 9.63 1.20 .41 1969 3665.30 10.44 1.30 .43 1970 3159.80 9.00 1.13 .58 1971 3705.75 10.56 1.32 .56 1972 4877.41 13.89 1.74 .48 1973 6634.09 18.90 2.36 .44 1974 8794.61 25.06 3.13 .44 1975 10204.60 29.07 3.60 .49 1976 10661.17 30.37 3.80 .53 1977 12006.65 34.21 4.28 .52 Q = 3.8 + 1.72 log L + .48 log K TABLE 6-2. ESTIMATES OF MARGINAL PRODUCTIVITIES OF CAPITAL AND LABOR FOR LIBYA 145 MPL MPL Year per year per week Per day Per hour MPK 1962 2915.37 58.31 8.30 1.03 1.28 1963 4065.45 81.31 11.58 1.45 1.64 1964 5864.23 117.28 16.71 2.09 1.69 1965 8040.78 160.81 22.91 2.86 1.63 1966 9830.39 196.61 28.00 3.50 1.64 1967 11013.67 220.27 31.38 3.92 1.73 1968 14730.14 294.60 41.97 5.24 1.80 1969 15942.27 318.84 45.42 5.68 1.86 1970 15816.48 316.33 45.06 5.63 1.91 1971 16984.53 339.69 48.39 6.05 2.57 1972 19267.17 385.34 54.89 6.86 1.92 1973 24003.95 480.08 68.39 8.55 1.61 1974 38021.00 760.42 108.32 13.54 1.91 1975 32439.69 648.79 92.42 11.55 1.57 1976 40109.22 802.18 114.27 14.28 2.00 1977 44764.24 895.29 127.53 15.94 1.97 log 0 = 3.8 + 1.72 log L + .48 log K 1.72-8 .48-g 146 ductivity of capital increased over time, but its behavior was erra- tic, probably for the same reasons that explain the pattern of beha- vior of marginal productivity of Egyptian capital. Third, all four estimates tended to confirm the original hypothesis, that is that marginal productivity of Libyan labor is higher than the marginal productivity of Egyptian labor. The estimates from RE1 yield an annual marginal product of labor ranging from $1251.22 in 1962 to $12006.65 in 1977, or from $3.56 to $34.21 per man-hour per workday. The marginal product per worker per year increased from 1962 to 1969, then declined for the next two years. The decline can be traced to the decline in the capital-labor ratio during the same years (as can be seen in Table 6-3). Except for two years, the capital-labor ratio grew at an annual rate of 15 percent over the period 1962-1977. This was the case with Egypt, where the decline in the capital-labor ratio was also consistent with the marginal productivity of labor. The marginal productivity of Libyan labor per hour ranges from $.45 to $4.28. The estimates are much higher than those for Egyp- tian labor. This confinms the hypothesis regarding the productivity of labor in both countries, that is that the productivity of Libyan labor is higher than that of Egypt. The main reason for the differ- ence in productivity is the abundance of capital that labor in Libya can work with. This can be seen directly from Table 6-3. Actually, labor productivity in Libya is higher than most estimates available for LDC's and most of the DC's. The "inflated" estimates are main- ly due to the oil sector and its unique position in the economy. CAPITAL-LABOR RATIO lN THE LIBYAN ECONOMY TABLE 6-3. Year K/L 1962 663.2 1963 692.9 1964 966.8 1965 1374.1 1966 1676.0 1967 1778.3 1968 2284.3 1969 2386.2 1970 1518.8 1971 1845.5 1972 2806.6 1973 4168.5 1974 5549.9 1975 5761.4 1976 5587.7 1977 6336.7 Source: 147 Computed from The Yearly Book of Statistics, United Nations, 1978. pp. 222-223. 148 Due to its capital-intensive nature, the oil industry has never employed directly more than 2 percent of the labor force, yet it contributes more than 60 percent of GNP. While this may not be a particularly unfortunate characteristic, since unemployment is not a pressing problem in Libya, it certainly contributes to the mis- leading conclusion that can be drawn from the earlier estimates. Until recently, the industry was owned and operated by foreign in- terests employing foreign capital and remitting abroad about 20 percent of the country's GDP (El-Jehaimi,p. 84). Furthermore, the oil produced is consumed, for the most part, in foreign markets, which means that the crude oil flows from the field to these mar- kets and has little impact on the national economy. Under such circumstances, oil is a "cheap" resource for Libya. That is to say, oil production as such places little pressure on the domestic supplies of scarce resources, including labor. Since oil production does not compete for local factors of production, the opportunity cost involved is virtually zero. Thus, when pro- ductivity is estimated based on the output of that sector, it is not surprising that it is so high. This can be seen from Table 6-4, in which estimates of productivity are presented for three sectors: agriculture, industry, and oil. In comparison to agri- culture, which is more endogenous, labor productivity in the oil sector averages one hundred times higher than in agriculture. The implication is that aggregate estimates inflate labor produc- tivity because of the oil sector. The marginal productivity of capital per million units for TABLE 6-4. ESTIMATES OF LABOR PRODUCTIVITIES PER MAN WORKDAY IN THREE SECTORS ($1000) Year Agriculture Manufacturing Oil 1962 .275 .930 7.057 1963 .275 .922 13.536 1964 .270 .949 21.254 1965 .374 .981 25.943 1966 .357 1.010 29.471 1967 .379 1.027 29.225 1968 .363 1.206 41.513 1969 .362 1.191 51.217 1970 .264 1.993 55.774 1971 .303 1.134 47.581 1972 .378 1.529 41.407 1973 .491 1.593 32.305 1974 .521 1.547 21.662 1975 .771 1.398 16.931 149 151) RE1 ranged from $0.55 in 1962 to $0.52 in 1977. As can be seen, capi- tal productivity increased only slightly throughout the period. This can be explained at least partially by decreasing returns, that is, successive additions of capital applied to a small population eventu- ally will yield a diminishing marginal contribution. Another reason is that most of the investment went to the industrial and agricul- tural infrastructure and was not immediately transferred into indus- trial goods or other output. Domestically produced goods continued to be only a small percentage compared to imports. For example, in 1972 the entire output of the industrial sector was barely 10 per- cent of the country's $845 million imports. Finally, as expected, the marginal productivity of capital in Egypt seems to be higher than in Libya. The previous analysis suggests that allocation of capital from Libya to Egypt will not decrease the productivity of capital. On the contrary, all indications are that its productivity will in- crease, especially if matched by labor transfer in the opposite direction. E. Factor Intensity Measurement of factor intensity can be accomplished through estimating the marginal rate of substitution (MRS) of the two fac- tors. Using equation 5.10, or the ratio of the respective marginal product, Table 6-5 provides estimates of MRS between capital and labor for the four regressions. Estimates of MRS of capital for labor range from $2277.60 in 151 TABLE 6-5. IMRS OF CAPITAL FOR LABOR-ESTIMATES IN 5 Year R1 R2 R3 R 4 1962 2277.60 163.60 1060.49 2635.16 1963 2478.90 178.52 1157.09' 2868.07 1964 3469.96 249.23 1614.99 4014.66 1965 4932.99 354.16 2298.15 5707.35 1966 5995.14 431.67 2391.35 6935.08 1967 6366.28 458.69 2972.96 7365.64 1968 8183.40 588.19 3824.39 9468.02 1969 8571.11 614.64 3986.93 9916.47 1970 8280.88 391.64 2537.47 6288.42 1971 6608.77 475.66 3080.91 7646.19 1972 10034.98 723.64 4697.55 11610.24 1973 14909.27 1073.52 6948.20 17249.70 1974 19906.28 1431.69 9269.94 20653.50 1975 20662.22 1482.73 9636.04 16186.55 1976 20054.60 1439.46 9343.70 23202.70 1977 22722.97 1634.78 10572.95 26289.90 152 1962 to $22722.97 in 1977 for R1. This indicates that in 1977, for example, it took $22722.97 to replace one worker. R4 gives a simi- lar result, while R3 and R4 give lower rates for the substitution between capital and labor. In all cases, the MRSk, is a large posi- tive number, indicating that a great deal of capital can be given up if one more unit of labor becomes available. This demonstrates the capital-intensive nature of the Libyan economy. In contrast, for the Egyptian economy, as we have seen, where much labor is already being used, the MRS was low, signifying that only a small amount of capital can be traded for an additional unit of labor. The MRS of capital for Libya increased over time except for two years. The decline was caused by the decline in the capital- labor ratio. The increase of MRSk, seems to be intuitively reason- able. The more capital (relative to labor) that is used, the less able capital is to substitute for labor. In a sense, capital be- comes less potent as more of it is used. F. Estimation of AES Between Capital and Labor in Libya The share equations are: SkL = a1 + bnlnX1 + b,,x,; 6.13 where SkL and SLL are capital and labor share, respectively. The results of the estimates are: skL = .614 + .0386 lnX, - .0386 111x2 6.15 (2.60) (2.60) and 153 sLL = .386 - .0386 lnX, + .036 Tnx, 6.16 All coefficients are significant at a confidence level of 95 per- cent. Using the estimated parameters together with estimates of the remaining parameters, we compare the elements of| F] and calculate |F,,|. Using (2.20), the Allen partial elasticity of substitution between capital and labor is estimated to be °kL = .587. For the purpose of checking the monotonicity condition and the concavity condition, the distributive share values at sample mean and the Hessian matrix of partial second derivative are evaluated as follows. First, the results indicate that the estimated para- meters have significant t statistics at the 5 percent level of significance. Second, the distributive share values, evaluated at sample means of capital and labor, exhibit positive signs: SkL = .659 > O; S LL .341 > 0. Therefore, the monotonicity condition is satisfied. The Hessian matrix of partial second derivatives, H = f,, f12 = -.OOO463 .001568 f21 f22 .001568 -.00536 = +.OOOOOZB7 shows that although H does not exhibit a negative sign, its value is virtually zero. This indicates that the concavity condition is satisfied. 154 The Allen elasticity of substitution between Libyan capital and labor,‘-okL = .587, is positive, which indicates that the relationship between capital and labor is similar to that of Egypt. The impli- cation is that an increase in the price of capital of one percent will increase the amount of labor by 0.587 percent. The AES declined between 1962 and 1977, as shown in Table 6-6. The decline, which reflects the increasing difficulty of substitu- ting capital for labor, is a strong confirmation of labor scarcity vis-a-vis the capital abundance. This also can be seen in the marked increase in the share of capital (from .596 to .688) and in the decline in the share of labor. The only exception to this pattern is the period from 1971 to 1974, where AES increased re- flecting the influx of foreign labor. TABLE 6-6. ESTIMATES OF THE AES FOR THE LIBYAN ECONOMY AES of capital Distributive Shares Year for labor SK SL 1962 .540 .5964 .4036 Mean values .587 .6592 .3401 1972 1.218 .6852 .3148 1977 .513 .6861 .3139 G. AES and Income Share The average factor shares for capital and labor are .660 and .340, respectively. The share of Libyan capital is much higher than the share of Egyptian capital, and the opposite is true in 155 the case of labor shares. These estimates are expected, and reflect the initial factor endowment of each country. However, the share of capital in Libya appears to be high and is probably biased upward for two reasons. First, capital share is taken as property income from the national income account. This means that a large percen- tage of the oil revenue is included. As mentioned earlier, that revenue does not translate into productive capital, and the part which does always has a lag time. Second, due to insufficient data about the capital stock, estimates of gross fixed capital for- mation were taken as substitutes. Although the estimates are ad- justed for inventory and depreciation, they remain an approxima- tion to the capital stock. Furthermore, those estimates are pro- bably affected by the same upward biases affecting capital share. The small value of 0 indicates that the substitution between Libyan capital and labor is not easy. The sharply curved iso- quant implies that the marginal rate of substitution changes by a substantial amount as K/L changes. Within each economy, the low level of elasticity implies that the share of the factor whose price rises (declines) will also rise (decline). Next we will consider the relationship between 0 and factor shares when factors of production are reallocated. H. Policy Implications of Resource Allocation The effects of allocating resources discussed in Chapter 5 will be examined under three scenarios. In the first, we assume that only capital will be transferred from Libya to Egypt. In the 156 second, we assume that only labor will be transferred to Libya. In the third, we assume that capital is transferred from, and labor is transferred to, Libya. 1. The first scenario Transfer of capital from Libya to Egypt (a reduction in the total capital stock) will result in higher prices of capital, the rise depending on "how much" capital is transferred. Due to the capital surplus in Libya, a significant amount needs to be trans- ferred before prices will start to rise. The effect of higher prices of capital will change the amount of labor in the production process. Although labor and capital are substitutes, most likely the higher prices will not induce a sub- stitution on a large scale, since °kL<1’ which reflects labor scar- city. The decline in the capital stock and the moderate rise in its prices will probably lead to a small increase in the capital share. The share of labor most likely will decline only slightly, since the decline in capital prices will not induce much substitution. Finally, we have shown that the aggregate production function is well behaved (Appendix D) and because ka is positive. A decline in the capital stock will lead to a lower marginal productivity of labor. 2. The second scenario Labor transfer to Libya without capital transfer in the oppo- site direction will lead to an increase in the absolute and rela- tive size of the labor force, which in turn will result in lower 157 prices of labor. However, the lower prices will not lead to a large- scale substitution of labor for capital immediately because okL<1. Over time, substitution will most likely become easier; in the long run, there will be a decline in the capital share and an increase in the labor share. The productivity of capital will tend to in- crease, probably significantly. 3. The third scenario Reducing the capital stock due to capital transfer from Libya to Egypt will result in a moderate increase in its prices. Because of the difficulty of substituting labor for capital, the capital share will increase (given that the amount transferred does not out- weigh the price increase). This increase will be at least partially offset by the labor transfer in the opposite direction. The lower prices of labor will most likely initiate, in the long run, substi- tution of labor for capital, leading to a decrease in the capital share and an increase in the labor share. The effect on producti- vity, however, will be clearer and much easier to predict. Both transfers will work to decrease the capital-labor ratio, thus lead- ing to higher capital productivity. Finally, it should be noted that the effect of allocating capital and labor from and to Libya will work in the opposite direction; the first transfer will most likely work to increase the capital share, while the second will work to decrease it. 158 1. Summary The measurement of the aggregate production function for the Lib- yan economy revealed the capital-intensive nature of the economy as a whole. This conclusion was supported by the factor intensity analy- sis of capital and labor. The productivity estimates tend to confirm the hypothesis of high productivity of Libyan labor relative to Egyp- tian labor. This is due to the abundance of capital, at least part of which is translated into investment in human capital, which ulti- mately enhanced the productivity of labor. The estimate of the elasticity of substitution between capital and labor indicates that it is "difficult“ to substitute capital for labor. This difficulty is a reflection of the scarcity of labor. When the estimate was used to evaluate the impact of allocation of resources under three different scenarios, the analysis seems to suggest that transfer of capital to Egypt coupled with labor trans- fer in the opposite direction will lead to a decrease in the capital- labor ratio, thus leading to a higher capital productivity. The effect of allocating capital and labor from and to Libya will work in the opposite direction; the first transfer will most likely work to increase the capital share, while the second will work to decrease it. Chapter 7 The Integrated Economy A. Introduction In ChaptersS and 6 we estimated separate production functions for Libya and Egypt. In order to examine the effect of factor eco- nomic integration, a pooled production function for the integrated economy has to be estimated. Pooling two production functions for two different economies is rather cumbersome, because of the large number of variables and highly inaccurate method, because of the aggregative nature of the process itself, which usually poses both theoretical and empirical problems. The first problem is minimized by considering only the major variables (capital and labor) in each economy. The second can be ameliorated only slightly, however, by looking for other estimates that support the pooled results and by the interpretation and weight given to the final result. B. The Pooled Production Function We are interested in finding out whether the set of coeffi- cients in the two production functions are equal. Among the stan- dard statistical tools available for this purpose is analysis of variance, which is useful if we want to find out whether the inter- cepts differ, given that the slopes are equal. If, instead, we want to know whether the slopes differ, the appropriate technique is analysis of covariance. Actually, if the slopes differ, there is little point in testing for the equality of intercepts. 160 The Chow test (Chow, C.G., pp. 591-605), basically an analy- sis of covariance, is designed to test whether the regression coef- ficients estimated by assigning subsets of a given set of observa- tions to two or more different structures do in fact belong to the same structure. A major shortcoming is that if two regressions are different, the test will show that they are different without speci- fying the source(s) of difference; that is, whether due to the inter- cept, the slope, or both. A superior test, suggested by Gujarati (Gujarati, D. , 18-21), uses dummy variables and proceeds as fol- lows. Use of dummy variables in testiggfor structural differences. The two production functions for Libya and Egypt, respectively, are: log 0,, = a, + a,logL,, + 8,logK + U,, i=1,...16; 7.1 log 0,1. = a, + ,logL,i + 2logK + U,, i=1,...16. 7.2 The subscripts 1 and 2 refer to the two sets of observations, and the U's are stochastic error terms. It is assumed that U, has the same normal distribution as U,, with variance-covariance matrix I an identity matrix of the appropriate order. The dummy variable approach can best be illustrated by writing the pooled function as follows: * Q, = a0 + a,logD + a,logL, + a3logK, + a4logL, + * aslogK, + U, i=1,...32. 7.3 where D = dummy variable = 1 if the observation lies in the first 161 set, that is, Libya; and it equals 0 if the observation lies in the second set, that is, Egypt. In addition, * I'" ll DXLi. The dummy variable 0 is introduced in 7.3 in the additive and multi- plicative forms. The coefficient a, is the differential intercept, and a4 and a5 are the differential slope coefficients. If a1 is statistically significant, the intercept value of the Libyan pro- duction function is obtained by a1 + a0, a0 in this case being the intercept value of the Egyptian production function. If a, is stat- istically insignficant, then a0 gives an estimate of the common term of both functions. If 54 is statistically significant, the labor coefficient of the Libyan production function is a4 + a,, a, being the labor coefficient of the Egyptian function in this situation. If a4 is statistically insignificant, a, gives the labor coeffi- cient conmon to both functions. If a5 is statistically significant, the capital coefficient of the Libyan production function is a5 + a3, a3 being the capital coefficient of the Egyptian function. If a5 is statistically significant, a3 gives the capital coefficient common to both functions. Thus, with the help of the additive and multiplicative dum- mies, we can tell whether two linear regressions differ either in the intercept or the other coefficients. Finally, it should be pointed out that it is immaterial whether D=1 for observations in the first set or in the second set. The results are invariant. 162 C. Estimation of the Pooled Regression Recall that the estimated production functions for Libya and Egypt, respectively, are: loth -3.80 + 1.17 log L + .70 log K; 7.4 10901: = -4.11 + 1.22 log L + .29 log K. 7.5 The estimate obtained for the pooled function 7.3 is: loth = -4.11 + .31 log K + 1.22 log L + .29 log K - (.067) (2.34) (2.33) .41 log E + .42 log R. R"2 = .97 7.6 (.054) (2.00) Equation 7.6 shows that, first, the differential intercept is insignificant at the 5 percent level, implying that the inter- cept is not different for the two production functions. The common intercept is given by a0 (-4.11). Actually, the common intercept is close to that of equation 7.5. This indicates that the inter- cept of the Egyptian production function can be used as the inter- cept for the combined production function. Second, the differential coefficient of labor, a4, is statistically insignificant at the 5 percent level, implying that the coefficient of labor is the same for both economies. The common coefficient is given by a2 (1.22). Again, it should be noted that this is very close to the estimate of the labor coefficient of the Egyptian production function given in equation 7.5, and thus the coefficient from equation 7.5 will be used as the labor coefficient for the pooled regression. Third, the differential coefficient of capital, as, is marginally signifi- 163 cant at the 5 percent level, implying that the capital coefficient for Egypt is different from the capital coefficient for Libya. Fol- lowing the earlier discussion, then, the capital coefficients of Libya and Egypt are (.42 + 29) and (.29), respectively. Comparing these values with those given by equations 7.5 and 7.6, we can see that they are identical. In summary, in pooling the two functions we find no structural differences in the intercept or in the labor coefficients. The only structural difference lies with the capital stock. This is not sur- prising, however, since in pooling the two economies the quantity of labor “added" to the Egyptian labor force is very small relative to the amount added to the capital stock. This is most likely the rea- son for the significance of the differential coefficient of capital. Furthermore, this probably indicates that the new integrated economy will be more capital intensive. If a2 and a4 are dropped from equa- tion 7.6, and if the new estimate shows no significant change in the remaining coefficients, then this can be a sufficient ground for pooling the two production functions. Equation 7.7 shows the estimate when the variables 0 and E are dropped: log ot = -3.8 + 1.19 log L + .29 log K + .41 log k, 7.7 (8.06) (3.07) (6.90) .,2 = .97 All coefficients are highly significant at the 5 percent level. Comparing equation 7.7 to 7.6, it can be seen that there is no sig- nificant change in the coefficients of L, K, and R. 164 0. Estimation of AES Between Capital and Labor in the Integrated EConomy The results of the "pooled” share equations are: * * 2 5K = .526 - .12131nx, - .1213lnX, R’ = .88 7.8 (15.13) (15.31) sL = .474 + .1213lnX, - .1213lnX, 7.9 Both coefficients are significant at confidence level of 95 percent. Using the estimated parameters together with estimates of the remain- ing parameters [implied by the restrictions bij = bji (i f j)] and constant returns to scale, we compute the elements of [F*| and calcu- late IF,,|. Using 2.20, the Allen partial elasticity of substitu- tion between capital and labor is estimated to be .728. The distributive share values evaluated at sample means of capital and labor exhibit positive signs: SK .657 > 0 SL .343 > 0 Therefore, the monotonicity condition is satisfied. The Hessian matrix of partial second derivatives, * f1, f1, -.0001042 .0003768 lH' = = f,, f,, .0003768 -.0001284 H’ = -.00000001 'A' * shows that H exhibits the semi-definite sign (TH |zozoom ooh O, the denominator of this function is positive; hence the whole fraction will be negative, providing the numerator is negative. Because f,, and fkk are both negative, the numerator will 206 definitely be negative if fkl is positive, which is the case for both economies. A positive fkl means that an increase in L will increase MPk, and vice versa. oo cwpcmo .NHN .o .HnooH .mmocmm,cnoeoocoz,eucommmm .oeHcceHo oweocouo meogumo uHEocouo one chmpuwooo m>HuouoHH< .moHoooopo> .< coo "muesom .ucmucmq o co Hm>oH zuHHHooooco e um oLmN scam pcmcmoowo xHuceuHoHcon moo mmHuHuHomon we» .mcowuuczo HHo come mooH . . . . . . . Loon ouconp< .suH>ougoo Ho H mm N Hm H mm em on ow .uomgz .oooeoo oomH zmmomgo .coemcoo om. oo. Hm. mo. mH. oH. om. omxwz oczoc< new Hozoco< .opocH coepo oooH .ocoz oo. oo. eo.~ oo.H Hm. we. om. mHooemo :mrHWP mooH memo gmmooca .coemcoo mH.N oo. oo. Ho.H om. mm. mo. Leona Lopes; new Hozoco< .pomgz .owocH mooH . . . . . . . msemoo .monooouo> Ho om so oo HH oH co ooxpz .muomco oeoH somH .mecom <2 <2 <2 mm. mm. oo. oo. mHooeo Hogmcmo moocH oN.H o.o Ho. oo.H oH. nu. oH. omxH: oHoemuooo mucmemomm mmuw>cmm ocoH cooeH 23o mmuH>me ocoH coooH moweLom mHQEom oo Loomo Locuo mo amok cowuouoH pmou Huwcoucoomo op uuaoogo Hae_meaz to emcee ecoHuuaooeo mo Huwuwpmon mmHoohm onhuzoo onHuzoomo Hthohmooao o» buooomo H O. (L) (Pk) Furthermore, the marginal rate of substitution, R, is equal to aY 12.33.91. 6,131” =Pk (3) fl 3K 176' 1:: 8L Dividing both sides by UK, 32‘. . go (I); If o>1 (p1.