The following points highlight the three main reasons for the Failure of Investment Multiplier in an Underdeveloped Economy. The reasons are: 1. Disguised Unemployment 2. Inelastic Supply of the Needed Consumer Goods 3. Lack of Excess Capacity in the Consumer Goods Industries.
Reason # 1. Disguised Unemployment:
For an efficient working of the multiplier, the Keynesian assumptions of involuntary unemployment, of excess capacity, of elastic supply of labour and capital must be fulfilled.
These conditions are obtained in advanced economies only.
In an underdeveloped economy a large part of the unemployed labour force, which is unskilled, is found in the agricultural sector.
Labourers are tied to their family farms and seem to enjoy a real income which gives them probably the same satisfaction as they would get when fully employed. This type of disguised unemployment can hardly be called ‘involuntary’ since it cannot be removed through employment at the current wage rate.
Therefore, higher wages along with other incentives are needed to remove them from their farms. In other words, it means that more output can be obtained only at a higher cost. To the extent additional labour and resources are not available at the current money wage rate; increase in employment cannot follow an initial increase in investment.
Reason # 2. Inelastic Supply of the Needed Consumer Goods:
Since the supply of consumer goods which the consumers want to purchase with an income increase is inelastic, the conclusion then is that in an underdeveloped economy, the secondary and tertiary rounds of multiplier do not follow as a result of an initial increase in investment, even though the MPC is very high.
Whenever additional investment is made, it leads to a rise in the demand for food and cheap industrial consumer goods amongst the working people and to increased demand for luxury imports amongst the rich classes. Agricultural output is inelastic, at least in the short period: whatever little increase in output takes place, it is consumed on the farm itself and is not brought to the market. Thus, an increase in investment increases incomes of the farmers in the primary sector in the first round but not in the successive rounds. Increased investment expenditures result in a contraction of the marketable surplus of the most essential consumables and generate a price spiral.
Reason # 3. Lack of Excess Capacity in the Consumer Goods Industries:
Even though the additional income goes to people who want to spend it on durable consumer goods manufactured in industry, the multiplier process does not work because of the limited capacity of the industries producing such goods. An example is scooters and small cars. Money incomes may multiply but real incomes do not increase much. The Real Income Multiplier turns into a Price Multiplier.
Therefore, “the income multiplier is much higher in money terms than in real terms and to that extent prices rise faster than an increase in aggregate real income………..the multiplier principle, therefore, works with reference to money but not with reference to real income or employment.”
The line of argument presented above is quite convincing and does corroborate at least Indian experience during the last 20 years. However, it does not mean that the concept of multiplier itself is useless for all thinking about growth of underdeveloped economies. Contemporary literature on growth economics has made use of many variants of the concept.
Most of the critics have viewed the operation of the multiplier process in a completely static setting as a purely short-period concept; this is all right for analysing economic fluctuations in economic activity, but the very rationale of economic development is long-run dynamic change.
When we take a long period view, the capacity-creating aspect of investment also becomes relevant besides the aspect of income-generation with which Keynes and his critics are concerned. Thus, in the context of planning for economic development, multiplier becomes a very important concept to work with even though the short-period workability of the income generation process is severely restricted.
So far, we have assumed that consumption is a function of disposable income. It is, however, a function of other variables as well. Now, we consider these variables. Before doing so, we shall consider alternative explanations of the relationship between consumption and income. The first explanation, the absolute income hypothesis, stresses that consumption is a function of the absolute level of income.
The second explanation, the relative income hypothesis, emphasizes that consumption is a function of current income relative to the highest level of income previously attained. The third explanation, the permanent income hypothesis, stresses that consumption is a function of permanent income, a long-run concept.