Relative prices and investment: an essay on resource allocation

Abstract

In this essay the mainstream story about how resources are allocated in a market economy is challenged. The conventional view is that a change in relative prices leads to a change in the composition of output as a result of a reallocation of the stock of primary factors of production (land, labor and capital). No investment is required. This is possible, however, only if the primary factors of production are homogeneous and hence highly mobile. If land, labor and capital are heterogeneous and specific to particular economic activities, resources will not be mobile and the ability of an economy to respond to price incentives will be highly dependent on the rate of investment in natural, physical and human capital. The argument is illustrated by considering the response of economic agents to changes in the relative price of annual and permanent crops, a change in agriculture’s terms of trade, structural adjustment and trade liberalization in sub-Saharan Africa and systemic change from plan to market in the former Soviet Union