The Returns to Infrastructure (Infrastructure and Development)

11Aug16

Most economists agree that infrastructure investment is necessary for a country to industrialize. From a development perspective, infrastructure offers two benefits: 1) it raises productivity and reduces the cost of private production, and 2) it has a disproportionate effect on the incomes and welfare of the poor by reducing costs to access markets, raising returns on existing assets, facilitating human capital accumulation, and facilitating agglomeration economies and the dissemination of knowledge.2 Measuring the returns of infrastructure investment is a challenging exercise that has dogged economists for centuries.

A recent revival in measuring the returns to infrastructure was pioneered by Aschauer (1989) who empirically found very high rates of return on public capital in the U.S.—between 70 and 100 percent. This and other studies suffered from serious methodological flaws, such as relying on expenditure as a measure of infrastructure investment or failing to account for reverse causality between income and infrastructure. Also, the use of aggregate time series data and the lack of microeconomic foundations have been criticized. A large literature has followed Aschauer’s contribution.

Calderón, Moral-Benito and Servén (2009) present new estimates of returns to infrastructure that are very robust and address many of the methodological shortcomings of previous studies. Their estimates of the output elasticity of infrastructure, which rely on a multi-dimensional measure of the physical stock of infrastructure as opposed to infrastructure spending, lie between 0.07 and 0.10. In other words, a 10 percent rise in infrastructure assets directly increases GDP per capita by 0.7 to 1 percent. These estimates are in line with recent estimates from meta-studies.

There is little evidence that output elasticities with respect to the inputs of the aggregate production functions differ across countries. In particular, the output elasticity of infrastructure does not seem to vary with countries’ level of per capita income, their infrastructure endowment, or the size of their population. Hence, the marginal productivity of infrastructure is higher in countries with relatively lower infrastructure endowments.

Before identifying the optimal amount and type of infrastructure spending, the benefits to infrastructure investment must be compared to the opportunity costs of infrastructure spending. Moreover, there exists only a weak link between infrastructure spending on the one hand and the stock of assets and quality of services on the other. This reflects big cross-country differences in efficiency and quality of governance.

To the extent that infrastructure is vital for a country’s economic development, it is also crucial in improving the quality of life for the poor. (See Straub, 2010.) Newly connected poor customers generally enjoy large welfare gains from new infrastructure, especially if they involve improvements to water and sanitary services as well as electricity.

A key benefit of infrastructure, in particular transport infrastructure, is the reduction of transport costs, which helps to create new markets and realize the returns to agglomeration. This in turn fosters competition, spurs innovation, lowers prices and raises productivity, leading to an increase in living standards.

Powerful evidence in favor of this benefit is supplied by Li (2010) for the case of China where the current level of transport costs is still the most significant trade friction (approximately half of total sales costs) and by Brooks (2010) for Asia more generally. China’s investment intensity has increased dramatically since 1990, with highway investment constituting the largest share. By looking at the price wedge of the same products in different cities, from which trade costs can be inferred, Li studies the impact of the Lanzhou-Xinjiang railroad. Within three years of the railroad’s completion, eastbound trade volume increased by over 40 percent and eastbound trade costs decreased by about 30 percent, implying a social return to the investment of approximately 30 percent per year.

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