• - employment and the labour market
• - access to finance capital
• - land, natural capital and comparative advantage
• - human capital and dynamic comparative advantage
• - complementarities between public and private investment
• - summary

The structure of incentives in an economy has a pervasive influence on the pace and pattern of development. Public expenditure is of course important, in some cases decisive, but in the great majority of developing countries the public sector employs directly only a small fraction of the labour force and produces substantially less than half of all goods and services in the economy. Most people obtain their livelihood outside the public sector, in the private sector, and most goods and services originate there. What is produced, how much is produced and what methods of production are used are questions decided largely in the private sector and primarily in response to the set of incentives which the private sector faces. The set of incentives, in turn, is strongly influenced by public policy, both directly and indirectly, and hence in formulating a human development strategy a good place to begin is by examining the structure of incentives.

It is often assumed that the structure of incentives in an economy can be fully described by the set of relative prices that prevails and some economists reduce the incentives issue to exhortations about "getting prices right". The view taken here however is that prices constitute only a part, albeit an important part, of the structure of incentives. Equally important are barriers which exclude people from participating in some markets, as happens with licensing regulations; or features of an economy which restrict the ease of access of some people to markets, such as the restricted access of small businesses to formal sector credit markets; or overt discrimination which reduces occupational mobility and income enhancing opportunities of some people because of their racial, ethnic, gender or other characteristics, such as the customary discrimination against "untouchables" in India. Also important are cases of missing markets, where economic activity occurs without market mediation and consequently the output that is produced is not explicitly valued. An important example is labour performed by females within a household economy.

Thus the structure of incentives includes all activities whether mediated by the market or not. And in the case of market mediated activities, it includes discrimination, barriers to entry, market access and of course relative prices. The non-price aspects of the incentive system often are overlooked, yet as we shall see, they can have very large implications for human development.
 

Employment and the labour market

Women account for approximately half of the population, yet in the developing countries as a whole they represent less than a third of the labour force. In many countries the majority of women of working age are not classified as being in the labour force, i.e., according to official statistics they are not performing useful work. This of course is nonsense. The "missing" female workers are engaged in a multiplicity of tasks -- nurturing infants, educating pre-school children, caring for the sick, collecting water and fuel, preparing meals, managing the household. What distinguishes these activities from others is that the persons performing the work (women) are unpaid and the output produced (goods and services consumed within the household) is not valued by the market. This is a massive instance of missing markets.

Because of the statistical invisibility of much work performed by women, many human development projects with potentially high returns fail to be implemented. These include projects which economise on the time of women and thereby reduce costs as well as projects which enable women to produce more in a given period of time and thereby raise total output. Examples include investments in village water supplies (which save time spent fetching water), in fuel-efficient stoves (which save time collecting wood), in schooling for girls (which ultimately raises the productivity of women workers and reduces fertility rates) and in nutrition programmes (which improves the health and ultimately the productivity of all members of the household). The present structure of incentives is strongly biased against investment in these and similar areas and governments wishing to promote human development would do well to bring under the calculus of benefits and costs the many activities undertaken where markets are missing.

Apart from unpaid women producing unpriced goods and services, there are also women classified as being economically active, i.e., as being members of the labour force, but who receive no remuneration for their work. The most important example is in agriculture. In some parts of the world, especially in sub-Saharan Africa, women supply most of the labour used to grow food crops. The output of women's labour (cereals, pulses, vegetables, root crops) may well be valued by the market even when most of the production is for consumption within the household, but the labour of the women may not be valued by the market because, for example, it is applied to land owned by the male head of household or tenanted by the male head of household. The structure of incentives in this case may not be biased against the crops grown by women but it is biased against innovations which reduce the time and effort spent by women in cultivation, since the labour of women is treated as if it had no cost. Thus the returns on investments in improved hand implements used by women are overlooked, as are possibilities for substituting draft animal power for digging sticks, improved harvesting methods, better storage and food processing techniques, etc.

Where the structure of incentives treats the labour of women as a free good, women become an "invisible input" in the process of production. This phenomenon is widespread and has led to a pattern of development expenditure that is neither efficient nor equitable. Once again, governments wishing to promote human development would do well to recognize the full implications of the missing market for female labour.

Not infrequently labour markets are characterized not only by missing markets but also by obvious discrimination. The basis of discrimination can be almost anything -- gender, race, ethnicity, language, religion, citizenship -- and seems to be limited only by the imagination of humankind in devising plausible criteria for distinguishing one group from another. Discrimination need not of course be restricted to the labour market and in fact economic discrimination often is reinforced by discrimination in the political and social spheres of life. In the economic sphere with which we are here concerned however, discrimination can be understood to serve two purposes: to reserve certain well paid, highly desirable occupations to a privileged minority and to confine certain groups to low paid, undesired occupations. That is, discrimination reduces the upward occupational mobility of the unprivileged groups, increases competition among them for the jobs for which they are eligible, and thereby increases the supply of workers at the lower end of the job ladder and reduces the wage rate. At the top end of the job ladder, discrimination reduces the supply of competing labour, restricts competition and raises the wage rate.

The most elaborate system of discrimination is that of rural India, where occupational segregation is intimately connected to the caste hierarchy. Elsewhere discrimination may be based on race, as in South Africa where blacks are largely restricted to mining, agricultural labour and low skilled jobs in urban areas. Even in Brazil, where overt discrimination is illegal, informal discrimination is widespread and there is a close correlation between skin colour and rungs on the job ladder, with black skinned persons on the lowest rungs and light skinned persons on the highest. In parts of east Africa and Southeast Asia discrimination is based on ethnic origin, with persons of south Asian origin being discriminated against in east Africa and persons of Chinese origin being discriminated against in southeast Asia.

Discrimination of course restricts choice and reduces opportunities; it makes it difficult and sometimes impossible for people to enlarge their capabilities and achieve their full potential. It is thus antithetical to the goals of human development. More subtle than overt discrimination are barriers to entry into certain occupations. In Andean America, for instance, those who speak an indigenous language (Aymara, Quechua) and wear native costume find it difficult to enter relatively well paid urban occupations or to obtain jobs in the public administration; they are effectively confined to the rural areas and to the informal urban sector. European dress and a knowledge of Spanish are used as barriers to entry into formal sector occupations, and the language barrier in particular can be quite formidable when low public expenditure on primary and secondary education in the countryside leads to low enrolment rates among the children of indigenous peoples.

Many occupations are in practice reserved for men -- politics, the legal profession, senior positions in the public administration, the police and armed forces -- and even when formal barriers to entry are absent, women often encounter "glass ceilings" which prevent them climbing to the top of the job ladder. Formal sector employment for women often is limited to filing clerks, shop attendants and domestic service and in countries where competition for urban jobs is especially keen, as in south Asia, even these sources of employment are reserved for men. The gender division of labour sometimes is defended on grounds that it reflects the culture of a particular country, but when women are denied choice, opportunity and avenues to enlarge their capabilities, "culture" should be seen not as a distinctive and valuable mark of civilization but as ideology sanctioning barriers to the human development of women.

The price component of the structure of labour market incentives, i.e., the set of relative wage rates, has received much attention. The thrust of the argument is that in general wage rates in the urban formal sector have been too high in the sense that the cost of labour to employers has exceeded its opportunity cost, i.e., the value of the output produced by the next best alternative use of labour. Many reasons have been advanced for the relatively high cost of formal sector labour: the wage policies adopted by the government itself for public sector employees, minimum wage legislation, the ability of labour unions to push wages above a market clearing level, etc. There is little doubt that in many occupational categories there is an excess supply of labour at the going wage rate, although the belief that these wages are inflexible downwards has been undermined by the sharp fall in real wages that occurred in the formal sector in east Africa during the severe economic crises of the 1980s .8

Whenever there is an excess supply of people seeking work at the going wage rate, there is at least a suspicion that employment opportunities could be increased, and human development thereby promoted, by lowering formal sector wages. This apparently simple remedy is more complex than first appears however. Whether some wages are "too high", even non-market clearing wages, depends on the context and the forces operating in the various labour markets. The labour "market" in developing countries is highly fragmented. In some cases markets are missing; in others there are numerous barriers to entry; in still others there is covert or overt discrimination. In addition, labour markets are segmented, with workers in the urban informal sector and rural occupations receiving very low remuneration and workers in the urban formal sector usually enjoying relatively high wages. These high wages, in turn, often are a result of decisions by firms to pay wages above the market clearing level to reduce turnover or, they are a direct result of government policy.

These fragmented and segmented labour markets should be seen as a whole, as a system of labour control. The structure of incentives within this system restricts the occupational and social mobility of a large portion of the population: it keeps people, men and women, "in their place". At the same time, it sometimes produces relatively high incomes for a very small but privileged minority of the labour force. That is, the structure of incentives leads simultaneously to an inefficient use of labour and an unequal distribution of income. Thus the issue confronting those who wish to promote human development is not that the price of formal sector labour is too high (i.e., above its opportunity cost), but that the structure of the labour market operates in such a way that a disproportionately large fraction of the labour force is compelled to seek a livelihood at the bottom of the occupational hierarchy, with the result that the remuneration of most workers is lower than it otherwise would be and in some cases (particularly for women) is zero. The policy implication is not to raise or lower a particular wage or set of wages but to reform the system of labour control.

None of this should be taken to imply, however, that a highly "fluid" labour market, with high turnover and little sense of loyalty or commitment between employer and employee, is preferable to a more "rigid" labour market in which formal sector workers enjoy security of employment. A combination of relatively high wages (to reduce labour turnover) and job security (to encourage workers to invest in firm specific human capital and to cooperate in the introduction of technical innovation), as in Japan, may actually be more efficient in the long run than labour markets which conform to the textbook descriptions of perfect competition.9
 

Access to finance capital

Many of the issues that arise in trying to understand the structure of incentives in the labour market also arise when studying the capital market. In many developing countries the most prominent feature of the capital market is its structural dualism, i.e., its division in two parts, a formal and an informal sector. The formal financial sector contains commercial banks, insurance companies, perhaps a stock market, a government established and operated development bank, and perhaps a housing finance institution. These institutions cater to the needs of large, well established industrial and service enterprises (domestic and foreign), the wealthy (for personal loans), the upper middle class (in the case of mortgages) and, in the rural areas, large farmers, ranchers and plantation companies. The informal credit market -- the black, grey and curb markets -- consists of pawn shops, money changers operating on city sidewalks, professional rural money lenders, shopkeepers who also provide credit for their trusted customers, large landowners who provide credit for their tenants, and friends and relatives who occasionally come to the rescue of those in distress. The informal credit market thus serves the majority of the population, small businesses in general, the urban informal sector, peasant farmers, the poor.

The formal credit market differs from the informal credit market in terms of price and ease of access. Prices charged in the formal credit market are relatively low. Nominal rates of interest are modest, sometimes below the rate of inflation, and consequently real rates of interest may even be negative. The low cost of credit to borrowers leads to enormous excess demand in the market and hence severe credit rationing. Those who succeed in obtaining cheap credit, however, have a strong incentive to invest in mechanised techniques of production, i.e., to economise on the use of labour and human capital generally. The result is an inefficient allocation of finance capital (an excessive degree of mechanisation) combined with an unequal distribution of income (because the chosen factor proportions shift value added away from wages towards profits and rents).

The rate of interest in the informal credit market varies over an enormous range. In some cases it is zero (e.g., occasional loans among relatives); in other cases real rates of interest can be extremely high (e.g., seasonal credit supplied by money lenders to small landowning peasant cultivators); while in other cases the rate of interest is indeterminate (as when factor markets are interlinked and landowners, say, offer their tenants a "package" of land use, credit and marketing services in return for a share of the crop intended to cover rent, interest and transport costs).10 In general, however, the cost of credit in the informal capital market is a multiple of the cost in the formal capital market and this provides a strong incentive for borrowers to adopt excessively labour intensive methods of production, with the result that the productivity of labour and hence labour incomes are lower than they would otherwise be. That is, incentives generated in the formal credit market encourage borrowers to reduce the employment of labour, whereas incentives generated in the informal credit market force borrowers to adopt techniques which reduce the productivity of labour and the earnings of working people, including the self-employed. In both cases the set of incentives is inimical to human development.

This outcome arises from persistent differences in ease of access of different groups of people to the formal and informal credit markets. If the two markets were closely integrated discrepancies in interest rates and in the cost of capital in general would be reduced by arbitrage to differences in risk, transaction costs and the cost to lenders of acquiring information. Actual differences in the cost of capital between the informal and formal credit markets, however, are much greater than can be justified by risk premia and the costs of doing business. The differences are so great because the degree of integration is low; for practical purposes the two markets are virtually separate. Illiterate farmers, self-employed itinerant vendors, fishermen, rural artisans, small shopkeepers, urban informal sector producers and workers, small businessmen engaged in urban or inter-provincial transport, and women in general have little or no access to the commercial banking system. They are forced to rely on the informal credit market and many persons are unable to obtain credit even from that source. They are excluded by their inability to read and write, by unfamiliarity with administrative procedures, by lack of collateral and by insecure legal titles to their property.

A human development strategy should seek to improve access to credit markets not by passing so-called anti-usury laws but by increasing the supply of credit channelled through the informal credit markets and by changing the characteristics of informal sector borrowers so they become more credit worthy. Anti-usury laws directed at money lenders and other informal sector suppliers of credit, far from lowering interest rates, will instead reduce the supply of credit, raise costs of lending and actually push up informal sector interest rates. Such legislation will only make matters worse. Instead the government should work with the informal sector lenders, channelling funds through informal sector institutions in order to increase the availability of credit and lower its cost. There is no need, however, for the government to go to the opposite extreme and subsidize credit by lending at artificially low interest rates.

In some societies women have particular difficulties obtaining loans for small scale economic activities, partly because they are not allowed to own or in practice do not possess property that can be used as collateral. In many parts of the world, but particularly in Africa, women have attempted to overcome discrimination against them in the credit market by forming rotating savings and credit associations or other cooperative arrangements. 11 In other cases banks have been formed which combine small loans and technical assistance to women, the loans being secured by the commitment of a group of women to assume responsibility for each other's debts. The most famous example is the Grameen Bank in Bangladesh.12 Government support for such initiatives can go part way to increasing the supply of credit in informal capital markets.

Access to credit can be improved through increased literacy (which enables borrowers to enter into formal loan contracts), by expenditure on primary and secondary education in rural areas (which builds self-confidence and familiarity with routine administrative formalities) and by providing secure titles to land and other assets. In many developing countries, especially in Latin America and parts of southeast Asia, private land tenure is insecure. This affects small cultivators in particular and notably those on the margins of the cultivated area who have cleared forests to bring more land under the plow. Adjudication of ownership claims often takes years and meanwhile property rights are insecure. This, in turn, has three effects. First, insecurity of tenure discourages long term investment in immovable assets. It creates a disincentive to increase the stock of natural capital -- land improvements, conservation measures -- and to invest in certain types of complementary physical capital -- fences, barns and other structures. Thus the set of incentives actually encourages environmental degradation. 13 Second, insecure titles reduce the price which land can fetch in the market, and this provides an incentive for the wealthy, who can afford the time and cost of adjudicating property claims, to purchase land from the poor at a discount. This then leads to increased inequality in the distribution of wealth. Third, insecurity makes it difficult for small farmers to raise credit from the commercial banks because formal sector lenders are reluctant to supply capital to those without clear titles.14 Thus a weakness in the land market, namely insecure private tenure, raises a barrier to entry into the formal sector capital market.

Looking beyond capital markets to the distribution of investment opportunities, it is often assumed that one of the things that distinguishes the informal sector of the economy from the formal sector is an absence of barriers to entry. In the informal sector -- characterised as it is by small, labour intensive enterprises, self-employment and low skilled services -- it is taken for granted that competition is intense and there is freedom of entry and exit. And at a certain level of analysis this description is undoubtedly correct. It is also the case, however, that informal sector enterprises often are prevented by law from competing with formal sector enterprises. A host of barriers to entry have been erected to protect the formal sector from competition from the informal sector. These barriers take the form of licenses, regulations, city ordinances and other controls which exclude informal sector enterprises from profitable activities in urban transport (taxis, buses, minivans), construction and food services and regulate competition by sidewalk vendors with formal sector retail establishments. The ostensible reasons for these regulations and controls are the health, safety and convenience of the public, but given that most of the public are poor people who would benefit from the freedom to compete and seek a better livelihood in highly profitable, protected activities, it seems that the real reason lies elsewhere, viz., in protecting the incomes of the relatively well-to-do.

Governments seeking to promote human development should re-examine their regulatory systems with a view to removing restraints on the growth and development of the informal sector. The structure of incentives faced by members of this sector tends to perpetuate poverty and inefficiency and to retard the overall rate of growth of the economy. Liberating the private sector could usefully begin by removing shackles which hobble the expansion and diversification of activities which potentially are attractive to people with only limited access to capital.15
 

Land, natural capital and comparative advantage

When designing a human development strategy, it is not enough to scrutinize labour and capital markets for possible malfunctioning; other markets should also be examined, particularly markets that supply widely used inputs that influence the structure of costs in a variety of economic activities. The land market is a case in point.

It has already been argued that insecure land titles contribute to the difficulties faced by small farmers in obtaining credit. The problems associated with land management and land use, however, go beyond the issue of private property rights. Publicly owned land often has been managed inefficiently, has accentuated environmental degradation and has benefited disproportionately the upper income groups. Encroachments on public lands (forests, grazing land, mountainous areas) is common. Because of poor management, public land often is treated as a free good; the resource base is "mined" and environmental damage can be extensive; the "tragedy of the commons" is the result. In southeast Asia timber pricing policies on public land have led to a waste of forest resources and a failure to replant.16 In Brazil, government subsidies and tax incentives have led to extensive clearing of the Amazon forest. Indeed, the only way to obtain title to land in the Amazon is by removing the trees from the land. 17 Similar problems arise with respect to the use of publicly owned subsurface water: it is often treated as a free good, is consequently used wastefully and the rate of extraction usually exceeds the recharge rate, thus ensuring that the process ultimately is unsustainable.

Heavy government expenditure on subsidies to fuel, chemicals and water has tilted incentives away from human capital in favour of intensive exploitation of natural capital. Fertilizer has been heavily subsidized in India and the other countries of south Asia with the result that surface water (rivers, lakes) and ground water supplies have become polluted. Subsidies to pesticides (and also to some extent herbicides) have led to a concentration of toxic chemicals in water and land, and in a few instances this has threatened to reduce biological diversity. Subsidies to fuel have encouraged agricultural mechanization at the expense of employment of labour. Perhaps most serious of all has been massive public investment in managed irrigation systems and the provision of water to farmers by the state at prices well below cost. In Egypt, irrigation water from the Nile is free; in Brazil and other parts of Latin America, the price of government supplied irrigation water does not even cover the variable costs of the irrigation system, let alone the capital costs; the same is true of publicly managed irrigation systems in north Africa, the Middle East and south Asia.

The set of incentives created by government intervention in market processes has had four unfortunate effects. First, it has damaged the environment and led to the depletion of the natural stock of capital through soil salination, deforestation, water pollution, etc. Second, as we will see in section 3, the government subsidies which underpin the set of incentives have absorbed a significant portion of the public revenues potentially available to support human development. The benefits of the subsidies have accrued not to the poor but primarily to upper income groups. Third, the structure of incentives has led to an inefficient use of resources; it has sent false signals to producers and helped to entrap developing countries in a pattern of production which is economically disadvantageous. The structure of incentives has led countries to adopt the wrong comparative advantage, to concentrate on products which are overly intensive in the use of natural capital and to neglect their potential comparative advantage in products which are intensive in the use of human capital. As a result, the shift out of primary commodity exports has been slower than it might have been and the creation of new comparative advantages in skilled labour intensive manufactured products and services has been delayed. Finally, the structure of incentives has led not only to static inefficiency in resource allocation and a pattern of trade that fails to reflect long run comparative advantage, it has also led to a pattern of investment that tends to perpetuate the status quo. That is, government subsidies to fuels, fertilizer, pesticides, water, timber and land affect not only the use of the existing stock of capital, whether natural, physical or human, they also generate political pressure from the beneficiaries of the subsidies for additional public investment in related areas (irrigation, state owned fertilizer plants, highways to open up virgin forests) and for ever larger subsidies to inputs. Once embarked on this road, it is difficult to change direction: vested interests can be expected to exert pressure to sustain existing programmes. Hence the need for reform-minded governments actively to build coalitions to support human development.
 

Human capital and dynamic comparative advantage

As suggested in the previous paragraph, compared to conventional strategies, a human development strategy is more conducive to promoting the long term comparative advantage of a developing country. Some developing countries may be endowed with an abundance of natural resources, but the costs associated with trying to exploit this comparative advantage for international trade have invariably been underestimated. When the true domestic opportunity costs of environmental degradation have been ascertained, many countries may not indeed be blessed with a real comparative advantage, certainly not at the rate at which they are exploiting their natural capital. Rather, their long term comparative advantage may be better cultivated by investing in human capital. If the development policies of governments have not reflected such an orientation, one of the major reasons is that the benefits of investment in human capital have not been fully recognized.

During the 1980s many developing countries still relied heavily on the export of primary commodities and confronted sharply declining terms of trade for these products.18 Those countries which succeeded in making the transition to exporting labour-intensive manufactures fared better. But even the terms of trade for manufactured exports began to show signs of decline.19 This underlines the importance for developing countries of developing a long run, dynamic view of their comparative advantage. If countries are to compete in a global economic environment undergoing dramatic change, driven in part by rapid technological innovation, it is essential that they continuously upgrade the skills and education of their workforce. For most countries this will require a significant reallocation of public sector resources towards programmes promoting human capital formation. One of the reasons that there is a low social rate of return on highly skilled labour in developing countries is that employment sometimes is not available for many of the people who complete a tertiary education. While there may be deficient demand for scientists, engineers, computer specialists, and other professionals now, if developing countries concentrate on enhancing their long run comparative advantage, these skills will be in increasing demand in future.

Enhancing a country's long run comparative advantage requires an activist state. This may not be a state which engages in large public investment projects, but it must be a state which attempts to influence the allocation of resources in the direction which best promotes the long term growth and development of the economy. Especially with regard to human development expenditures, which are characterized by many positive externalities and complementarities, the private market mechanism tends to under-allocate resources for such purposes. It is incumbent on the state to ensure that there is adequate financing for human capital formation, not only to increase present income flows, but also to ensure future high rates of growth.

If a developing country concentrates on human capital as the basis for its long run comparative advantage, this does not imply that it should follow an export-promoting or export-biased trade strategy. An export-promoting strategy biases domestic output towards supplying external demand rather than domestic demand and thereby subjects a country to the fluctuations and uncertainties of the international market. This strategy could be risky during a period in which protectionism has been on the rise in developed countries, the rate of the growth of the global economy has been slowing, and potentially exclusionary trading blocs are emerging.

A more sensible policy is one which fosters an open economy, but open in the sense that it biases production neither towards exports nor towards domestic demand.20 The exchange rate is not deliberately under-valued in order to boost exports artificially. Such a policy of undervaluation may enable a country to export a greater volume of labour-intensive manufactures based initially on its endowment of low-skilled labour, but it does not engender the competitive pressures that compel a country to make the transition to more human-capital-intensive exports.

Under an open economy trade regime neither is the exchange rate over-valued, since this would enable a country artificially to cheapen the import of capital and intermediate goods. Over-valued exchange rates have been characteristic of import substitution trade regimes. The policies of import substitution -- over-valued exchange rates, high tariffs, physical import controls, restrictions on foreign exchange and capital movements, and cheap rationed financial capital -- have fostered a capital-intensive structure of production in many developing countries and undermined their potential comparative advantage in labour-intensive exports. In general, the policies have biased investment towards physical capital and away from human capital. Pakistan represents a classic example of the distortions in resource allocation which result from import substitution policies.21

A trade orientation based on a comparative advantage arising from a relative abundance of human capital is not only likely to engender a more rapid rate of long term growth than one based on physical capital or natural capital, but it is also likely to distribute the benefits of such growth more equitably. In most developing countries ownership of land and other natural resources is unequally distributed, as is the ownership of physical capital. Exports intensive in the use of natural resources or physical capital mainly serve to enlarge the share of rents or profit in national income, whereas labour-intensive exports help to increase the share of wages.
 

Complementarities between public and private investment

Governments affect the set of incentives to which private producers respond and, because of the dynamics of the political process, state investment also is likely to respond to the set of government influenced incentives. In principle this is not undesirable. After all, if the set of incentives provides correct signals for resource allocation, it would be desirable for both the private and public sectors to respond to the same signals. If the signals are misleading, perhaps in the ways suggested above, this is an argument for changing the structure of incentives, not for reducing the level of government activity. That is, a defective set of incentives caused partly by government subsidies and other forms of intervention should not necessarily be interpreted as evidence of "government failure" resulting from incompetence or ignorance; it might simply reflect a different set of policy goals.

Many cases can be found -- Haiti is a glaring example -- where governments have been prepared to sacrifice efficiency, protection of the environment, growth and poverty alleviation for higher incomes for their supporters. The structure of incentives necessary to achieve this result may be highly successful in its own terms and it would be a mistake to claim that in such cases public policy is prone to "government failure" and future governments should abstain from interfering with the market. Moreover, even in genuine cases of government failure, it does not follow that the best solution is to reduce the scale of government activities. It might be more sensible to correct the failure, e.g., by increasing the information available to the government, by devoting resources to training programmes for civil servants, or by reforming the public administration to make it more accountable to the general public.

A human development strategy is likely to require an activist state. First, it will have to intervene to correct the bias in favour of products and processes of production which are intensive in the use of natural capital. If left to its own devices the market tends to ignore many costs which damage the environment. Second, it will have to intervene to correct the bias against human capital formation. If left to its own devices the market tends to ignore many of the benefits associated with expenditure on human development. Third, the state will have to be active in financing and undertaking investment broadly conceived, including expenditure on research and development, education and training, health and nutrition, as well as investment in many forms of physical capital such as transport, power and urban infrastructure.

It is sometimes claimed that public expenditure "crowds out" private expenditure and that the returns on private investment are greater than the returns on public expenditure. This is then used as an argument to reduce taxation and state spending. In the case of a human development strategy, however, this argument clearly is wrong: public investment, broadly defined, is complementary to private investment. We have here a case of "crowding in", not "crowding out".

Precisely because human development expenditures generate positive externalities -- benefits that are not fully captured by the market mechanism -- the state must take the lead in a wide range of activities from child nutrition programmes to investments in scientific research and technology. Once these state investments are in place, the private sector can appropriate the external benefits through investments of its own and in so doing obtain a higher rate of profit than would otherwise be possible. That is, the rate of profit on private investment varies positively with public expenditure on human development. At the same time, the benefits of public expenditure on human development are realised partly as a result of employment generated by private investment. Public and private investment thus are complementary to one another. The larger is expenditure on human development, the larger is likely to be the volume of private investment. In addition, the larger is expenditure on human development, the more even will be the distribution of income, everything else being equal, and partly because of its effects on private investment, the faster will be the overall rate of growth.
 

Summary

The structure of incentives refers not only to the set of relative prices that prevails in an economy but also to the degree of access to markets, barriers to entry and discrimination. In many developing countries the structure of incentives is in conflict with the objectives of human development and it will be important in designing a human development strategy to consider how best the structure of incentives can be improved.

Human development is much concerned with correcting market failures, particularly failures of factor markets. If left to its own devices the signals generated by an unrestricted market would lead to systematic underinvestment in the stock of human capital, including expenditures on training and apprenticeship programmes, all three levels of formal education, basic health care, pre- and post-natal maternal and child care and nutrition programmes. All of these activities have some of the characteristics of "public goods" and generate positive externalities. The market would also lead to underinvestment in research in science and technology -- because private firms cannot capture the full benefits of their expenditure on research and development (despite patents and copyright laws), because investment in scientific research is "lumpy" and characterized by economies of scale over a considerable range, and because individual research projects viewed in isolation often are risky and consequently are unattractive unless pooled in a large national research programme.

Labour markets in developing countries often are far from efficient. They are highly fragmented and sometimes segmented into non-competing or only partially competing groups. Discrimination against women and other groups in society is common. There are many barriers to entry into high paying occupations and access to formal sector employment is restricted. Wage rates fail to reflect the opportunity cost of labour, being too low at the lower end of the job hierarchy and too high at the top end. There is thus a strong case for a government committed to a human development strategy to become actively involved in improving the functioning of labour markets.

Broadly similar issues arise in the case of financial and capital markets. The price of finance capital in formal sector markets often is below the opportunity cost of capital, thereby discouraging investment in human capital and the creation of formal sector employment. In the informal sector, the price of finance capital varies widely but in general exceeds the opportunity cost of capital in the economy as a whole and this leads to the adoption of excessively labour intensive methods of production, low productivity and low earnings from employment. Here again, a strong case can be made for governments to intervene to improve the structure of incentives.

Market failures also produce adverse unintended effects on the environment. In the market for land government subsidies often reinforce and exacerbate pressures for the intensive exploitation of natural capital. Part of the problem arises from a neglect by private sector actors of negative externalities associated with production; another part arises from poor management of publicly owned land and its treatment as a free good; yet another part arises from poorly defined property rights (whether public or private) governing the use of many natural resources. Governments not only fail to correct the distorted incentive structures which damage the natural stock of capital, they intensify the problem by subsidizing fuel, chemicals and irrigation water used by farmers. These policies also place a heavy burden on government budgets and lead countries to follow a comparative advantage based on the intensive use of natural capital rather than human capital. Instead of alleviating the poverty which is a major cause in some countries of environmental degradation, government subsidy programmes enrich upper income groups and increase inequality in the distribution of income and wealth. One of the important lessons that has emerged from the current discussions on future directions for development is that human development is neither desirable nor possible without sustainable development. There is no inherent conflict between these two seemingly different objectives. In fact, compared to other strategies, a human development strategy relies on an incentive structure which is more compatible with protection and enhancement of the natural environment.

While the costs associated with the exploitation of natural capital have been underestimated, so have the benefits of investing in human capital. A failure to perceive this has led governments when formulating their trade strategies to neglect potential long run comparative advantage based on a skilled, educated labour force able to learn and apply technological innovations. Such a trade strategy requires an active state which takes into account the positive externalities generated by human capital formation and which by restructuring private incentives or by direct expenditure compensates for the tendency of the private sector to under-invest in human capital. The appropriate trade strategy is one which promotes an open economy, artificially biased neither towards export promotion nor import substitution. Such a trade regime is the most supportive of human development in the long run.

Defects in the incentive system often reflect not market failure but the policies of government itself. Special attention has been paid in the discussion to subsidies for water, fertilizer and fuel, although the full range of subsidies must also be considered when designing a human development strategy for a specific country. It is tempting to characterize policy interventions inimical to human development as examples of government failure, but this would be wrong. The government may simply have pursued different objectives and it would be pointless to accuse it of failing to achieve goals it did not seek.

Where there is genuine government failure, the best remedy may not be to reduce government intervention in the economy, as usually advised, but to correct the failure so that future interventions will do more good than harm. Government intervention and government expenditure are not regarded as desirable in themselves but because the very nature of a human development strategy requires an activist state capable of playing a leading role. Human development seldom is served by reducing public expenditure, but it often could be served by altering the composition of public expenditure. The strategy requires not that the government do fewer things but that it do different things. This is the topic of the next section.