Today’s column starts my discussion of the fourth of the top-ten development challenges that spending of Guyana’s expected significant “Government Take” will have to navigate in the coming years of oil and gas production and export. That is the economy’s absorptive capacity or lack thereof. I begin by asking: what is meant by this term?
Most laypersons to whom I have spoken seem to have an intuitive appreciation of what Guyana’s lack of absorptive capacity means. More specifically, several have directly expressed this as Guyana’s inability to efficiently spend its expected Govern-ment Take from the petroleum sector. Basically, this is due to their belief that there are major constraints and/or bottlenecks in the economy. This intuition is broadly speaking, correct. Particularly since economists’ shorthand description of absorptive capacity, put simply, is “local conditions.”
However, the concept of absorptive capacity was originally developed in the disciplines of business administration, organizational behaviour, and strategic management, not economics. Thus, the standard textbook definition of absorptive capacity still remains: “a firm’s ability to recognize the value of new information, assimilate it, and apply it to commercial ends” (Cohen and Levinthal, Administrative Science Quarterly, 1990). This concept has been subsequently broadened and applied to groups, as well as at the national and regional levels.
One way for readers to further their appreciation of absorptive capacity is to contrast it to innovation. Innovation requires 1) development of new products, which are “discrete improvements over existing ones,” or 2) “the redesign of products or services.” Absorptive capacity is, instead, the firm’s 1) adoption of a new product, or 2) its adoption of a new process. The upgrading of an old product or process is similar. What is always required for successful absorption is permission to utilize the relevant technology/process. Given this context, the phrase: “New to the Firm versus New to the World,” I believe, best sums up the distinction between Absorption and Innovation.
Over the years, empirical measurement of a firm’s absorptive capacity has followed a “four-dimensional scale” based on four attributes implicit to the description given in the above paragraph. These are: 1) the ability to acquire the requisite knowledge 2) the ability to assimilate it within the enterprise, after its acquisition 3) the ability to transform the assimilated knowledge to the firm’s benefit and, therefore, finally 4) the ability to exploit the knowledge commercially, within the enterprise.
In what follows, I shall show how this concept has been translated into development economics, with an emphasis on its measurement.
Absorption Capacity in Economics
In the Introductory Section above, it was noted that, broadly speaking, absorption capacity is referred to as “local conditions” of the economy. These local conditions are assumed, generally, to determine the ability of the economy to grow and develop. It, therefore, traces how changes in demand can have multiplier effects in an economy. Such effects depend on the responsiveness of the labour supply and its skills; the state of the physical and social infrastructure; the technological capability of the country; the financial, institutional and regulatory framework; and, more generally, what the World Bank assesses as the “ease with which business is done.”
All the features indicated in the paragraph above face potential constraints in Guyana. These limit the expansion and/effects of an autonomous injection of spending in the economy, including unprecedented petroleum revenues. In the traditional development literature, this feature is often commonly framed in the terms of the linkage of foreign direct investment (FDI)/external aid and/large increases in commodity export prices/to the growth of an economy.
As with the other top-ten development challenges, it is crucial to establish objective indicators, by which Guyana’s progress in navigating these can be more objectively rather than subjectively established. In the development literature, two lines of analysis have emerged early on in this effort. And, both lines agree with the perspective that absorption capacity can be defined and, therefore, measured as “the productivity of capital investment.”
Starting from this frame of reference, one line of analysis argues that “if, on the average, the investments in the economy are indeed productive, such an economy will have high absorptive capacity.” This leads to the further postulate that it is the prevailing “rates of return” which indicate how productive investments are in the economy. High rates of return on capital investments, therefore, are an indicator of high absorptive capacity. And, consequently, low rates of return establish the opposite, low absorptive capacity.
The second line of analysis, however, has drastically moved away from the productivity of investments and their rates of return, as described above, to a more “indirect causal connection” between capital investment and the flow of income in the national economy. In the National Accounts of any economy, investment (likewise consumption, government spending, and exports), is a component of its flow of income. In this flow of income, regular readers are aware that investment influences the flow of all the other national accounting sectors, including further investment itself!
Because of this feature, certain conclusions follow. First, productive investment always yields an increase in output or the national accounts. Second, following on this, the focus of absorption capacity shifts from capital investment and its rate of return, to the impact of capital investment on the National Accounts (output) and, therefore, economic growth. Third, linking productive investment to growth forces analysts to consider that the expected growth of output from an investment may or may not be realised. Whether or not the expected growth in output is realised, therefore, provides a clue as to a likely measureable indicator of absorptive capacity.
This approach to absorption capacity is clearly “growth-determined.” That is, it is focused on the National Accounts and changes to them (real and nominal) over time. Changes in the National Accounts measure economic growth. This approach, therefore, embodies all major components of the macro economy. There is however, in practice, a distinction between actual growth of the economy, and the desired growth of the economy. This distinction is captured in the analysis of potential output in an economy and the output gap between that potential and actual output, positive and negative.
Next week, I shall continue this discussion and also briefly address the output gap approach, as an indicator of absorptive capacity. Afterwards, I return to the next of the top-ten development challenges: the emergence of an Enclave Economy.