The implications of capital formation for the expansion of productive capacity depend not only on the volume of investment but also on the effectiveness with which it is used. Given the scarcity of investment funds in most developing countries, the maximization of the efficiency of investment assumes special importance in the context of development efforts. The efficiency of investment is influenced by its distribution among different types of assets and by the share in the total of renewals and replacements. New investment in construction will generally have a lower output-growth potential in the short and medium-term relative to investment in machinery and equipment, which is more closely tied with production and whose contribution to output is more condensed in time. Residential construction, which generally absorbs an important part of fixed investment, contributes directly very little to expanding the productive capacity of the economy. Investment in infrastructure tends to exert its influence on production over a long period of time, whereas its capital requirements are relatively large. Another factor which tends to reduce further the growth potential of investment in construction arises from the fact that much construction is undertaken by public authorities in connection with activities whose measured output is nominal or even non-existent. With respect to investment in renewals and replacement, the question revolves around the extent to which such investment provides an opportunity for taking advantage of technical progress. The distribution of investment for replacement among construction, machinery and equipment becomes irrelevant when replacement is of the pure and simple kind and is not associated with any changes in production methods. In practice, however, replacement investment is much more likely to act as a vehicle for technical progress when it consists mainly of machinery and equipment than when it is mostly construction. Thus, in the case of both new and replacement investment, the growth potential of investment will tend to be higher the greater the share of machinery and equipment in the total, and lower the more preponderant the share of construction.
A second major factor influencing the investment-output relationship is demand. This is particularly true of the industrial sector of many developing countries where the persistence of excess capacity is a common phenomenon and, consequently, output is highly responsive to changes in the level of demand. The same is generally true of the bulk of export commodities whose output can usually be expanded relatively rapidly in response to higher world demand with no, or only little, additional investment incurred.
The investment-output relationship is also influenced by the sectoral distribution of output and investment. It is worth mentioning that the importance of weather conditions in determining agricultural output in some countries, which means that output in one period might have little or no relation to investment incurred during the same or in a preceding period; and the overwhelming contribution that the oil sector makes to output in some countries - the high elasticity of output to investment in this sector will distort intercountry comparisons of overall levels of investment efficiency.
Besides the above enumerated influences, apparent intercountry differences in the efficiency of investment could have at their origin differences in the relative importance of increases in employment levels and in the suitability of the technology embodied in the investment to the prevailing resource endowments. Moreover, mere availability as such will not guarantee effective use. Allocation problems are also involved, as well as the supply of complementary resources, particularly those that have to be obtained abroad, and there are many organizational and institutional factors which can enhance or inhibit productivity.