Development and StructuralTransformation:

The Lewis Model

Dilip Mookherjee

Ec320 Lectures 9-10, Boston University

Sept 30 and Oct 2 2014

DM (BU) 320 Lect 9,10 Sept 30, Oct 2, 2014 1 / 26

Development and StructuralTransformation

The Harrod-Domar-Solow models aremacroeconomic theories of growth

A key distinction between growth and development:latter additionally involves changes in structure ofthe economyStructure: relative importance of

Rural versus UrbanAgriculture versus IndustryInformal versus Formal sectorsSmall-scale versus Large-scaleTraditional versus modern

DM (BU) 320 Lect 9,10 Sept 30, Oct 2, 2014 2 / 26

Development and StructuralTransformation, contd.

Processes of industrialization, urbanization andmodernization are important drivers of growth inliving standards

Because productivity and living standards differsignificantly between rural and urban areas, betweeninformal and formal sectors

Formulation of development policy needs to bebased on an understanding of why these differencesarise, and focus on speeding up structuraltransformationDM (BU) 320 Lect 9,10 Sept 30, Oct 2, 2014 3 / 26

Table: Breakdown of GDP Across Different Sectors, 1999

Agriculture Industry Services

Low Income Countries 27 30 43Middle Income Countries 10 36 55High Income Countries 2 30 64

DM (BU) 320 Lect 9,10 Sept 30, Oct 2, 2014 4 / 26

Table: Breakdown of Employment Across Different Sectors, 1990-92

Agriculture Industry Services

L/M Income Countries 58 15 27OECD 10 32 58

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Productivity and Living StandardDifferences between Rural and UrbanSectors

Fact of life: agricultural production is limited byscarcity of land

Industry and services not limited by any such fixedfactor

Technical progress and rising worker skills raiseproductivity in industry and services far more thanin agriculture

Hence development typically goes hand-in-hand withindustrialization and urbanizationDM (BU) 320 Lect 9,10 Sept 30, Oct 2, 2014 6 / 26

Informal versus Formal Sector Enterprises

Enterprises in the informal sector: unregistered,unregulated, outside tax net, low access totechnology and institutional finance

Few hired employees; high reliance on family labor

Most farms in LDCs are informal

Producing goods for self-consumption; notoperating on a commercial (profit-making) basis

As development proceeds, they switch to cash cropcultivation on a commercial basis

DM (BU) 320 Lect 9,10 Sept 30, Oct 2, 2014 7 / 26

Dualism within Urban Areaa

Large informal sector also exists in urban areas:selling services or low quality goods, orsubcontracting with formal sector firms

Coexists with formal sector: factories, banks,supermarkets, hospitals, government etc.

Vast gaps in wages, job security and workingconditions between formal and informal sector

Formal sector characterized by commercial principlesand legal contracts enforced by law

Informal sector by ‘customs’ and ‘norms’

DM (BU) 320 Lect 9,10 Sept 30, Oct 2, 2014 8 / 26

The Lewis Model of Development basedon Structural Transformation

Lewis (1955) models development as a process oftransformation of a traditional rural agriculturaleconomy into a modern urban industrial economy

Based on the observation that most traditionalLDCs have an almost ‘unlimited supply of labor’ inthe countryside and in the urban informal sector

DM (BU) 320 Lect 9,10 Sept 30, Oct 2, 2014 9 / 26

Rural Sector: Surplus Labor andTraditional Norms

Phenomenon of ‘disguised unemployment’ or‘surplus labor’ in rural sector: have low productivityjobs with lots of time to spare

Not hired on a commercial basis, but on the basis offamily/kinship relations or customary norms

‘Traditional’ wage w̄ is based on sharing norms,equals average (not marginal) product of labor

The rural wage is going to remain fixed at this level,until a later stage when labor scarcity arises in thecountryside and labor markets emerge

DM (BU) 320 Lect 9,10 Sept 30, Oct 2, 2014 10 / 26

Industrial Sector

Industrial sector: factories owned by capitalists,operated on commercial lines

Wage rate in industry equals marginal product oflabor

Main impetus for growth and development:investment in new factories by capitalists

DM (BU) 320 Lect 9,10 Sept 30, Oct 2, 2014 11 / 26

Rural-Urban Migration

Workers can migrate from rural to urban sector

Unlimited (initially) supply of labor in rural sector

Hence urban wage equals (is determined by) the(given) rural wage w̄

DM (BU) 320 Lect 9,10 Sept 30, Oct 2, 2014 12 / 26

Inter-Sectoral Labor Misallocation

Let P denote the cost of living in the city forworkers (price of food relative to industrial good(numeraire))

In industry, workers hired tillMP I

L = P ∗ w I = P ∗ w̄ = P ∗ APAL > 0 = VMPA

L

Productivity difference between the sectors:VMP I

L > VMPAL = 0

Rural-urban migration would raise GDP, but won’thappen by itself in the free market

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What Determines Migration?

Creation of jobs in the industrial sector, owing toinvestment in new factories by capitalists

Rate of investment in new factories equals savingsof capitalists (workers are too poor to save)

Savings of capitalists equals capitalist profits timestheir saving rate

Like the Solow model, growth rate depends oninvestment in new capital

Lewis Assumptions: no investment in rural sector;capitalist m.p.c. on food is zero

DM (BU) 320 Lect 9,10 Sept 30, Oct 2, 2014 14 / 26

Three Stage Process of Development

Stage 1: Workers move from agriculture to industryat a rate determined by new industrial investment:

MPAL remains zero (drawing down of surplus labor)

food supply (hence P) remains fixedindustrial wage is fixed at P ∗ w̄

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Three Stage Process of Development,contd.

Stage 2: starts when surplus labor in rural sectorends and MPA

L becomes positive

Continues as long as MPLA remains below w̄ : nolabor scarcity yet in rural sector

Wage continues to be w̄ in rural sector

But food supply falls, causing urban cost-of-livingfor workers P to rise

Raises wage that workers must be paid in urbanareas, reducing capitalist profits and rate of growth

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Third/Last Stage of Development

Stage 2 ends when MPAL = w̄ : labor scarcity in

countryside

Agriculture becomes commercialized: labor marketsemerge

Farms hire workers on the market, until MPAL = wA

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Third/Last Stage of Development, contd.

Agricultural wage wA now starts rising owing togrowing labor scarcity

Resulting in further reduction in capitalist profitsand industrial growth rate

Economy is now modern and mature; no spatialmis-allocation any more (VMPA = VMP I )

Solow model works from now on

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Features of the Lewis Developmentprocess

Similarity to Solow growth process: once anindustrial sector and capitalist class emerges,development proceeds more or less automatically

Driven by investment in new industrial capital

Rate of growth slows down over time

But not owing to (technological) diminishing returnsto industrial investment

Instead: limited by availability of food and laborfrom the countryside

DM (BU) 320 Lect 9,10 Sept 30, Oct 2, 2014 19 / 26

Inequality in Lewis Development process

Unevenness of development pattern

Benefits of development in early stages accrueentirely to capitalists

Why inequality tends to rise in early stages

Benefits flow down to workers only in last stage

DM (BU) 320 Lect 9,10 Sept 30, Oct 2, 2014 20 / 26

Role of Agriculture in EconomicDevelopment (Eswaran-Kotwal, Ch 8 inUP)

Model focuses attention also on role of agriculture:Need to prevent critical shortages in supply of foodand workers which lower growth rates by raisinginflation and industrial wage costsComplementarity between agriculture and industryin early stages of development (e.g., India and Chinavs Russia)Become substitutes later on, during the third stageof the Lewis processDM (BU) 320 Lect 9,10 Sept 30, Oct 2, 2014 21 / 26

Role of Population Growth

Lewis theory differs from Solow theory also withrespect to effects of higher population growth

In first stage, higher population raises demand forfood and cost of living, hastens onset of secondstage, so has negative effect

But it helps prolong the second stage, by preventingrapid emergence of labor scarcity

Trade-off between food shortage and labor shortage

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Role of Globalization

If the developing country has access to a world foodmarket, the price of food is constant, whicheliminates the transition from the first to secondstagePrevents food shortages: helps prolong first stageAbility to export industrial goods raises growth rate,while competition from foreign imports slows downgrowthForeign investment raises growth rate, but foreigninvestment tends to fall in second and third stagesowing to declining capitalist profits (Thailand, Chinaexperience)DM (BU) 320 Lect 9,10 Sept 30, Oct 2, 2014 23 / 26

Implications for Government Policies

Minimum wage legislation in urban sector slowsdown growth and creates urban unemployment(next lecture)

Early development creates pressures (esp indemocracies) to promote redistribution fromcapitalists to workers, which slow down growth

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Implications for Government Policies,contd.

Need for government to promote agricultural growthfirst (via land reform, investments in infrastructureand technical diffusion), to support industrial growth

Trade policy: need to ensure access to cheap foodimports to keep growth rates high (Corn Laws inearly 19th century UK)

Need to attract foreign capital inflows

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Critique of Lewis Model Assumptions

Surplus Labor assumption not applicable in somecontexts (eg Africa in 1960) (next lecture)

Agriculture sector: traditional family farms, no labormarkets, no technical progress, no scope forinvestments

No role assigned to human capital investments andits importance in industrial progress

Assumptions concerning motive for migration:‘selfish’ migrants

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