The Lewis Model

Describe carefully the Lewis dualistic labour surplus model. Does the Lewis model describe accurately the process of economic development in poor countries?

The Model

The Lewis model proposes a dualistic economy consisting of a formal, industrial and urban sector, and an informal, agricultural and rural sector. The formal sector is characterised as capital intensive and being run by profit-maximising capitalists who hire labour until the wage rate equals the marginal product of labour. This is because it makes economic sense for a firm to continue to hire labour until the costs (wage) equal the benefits (the marginal product of the additional unit of labour). If wage>MPL then it would make sense to let workers go and if wage<MPL then it would make sense to hire more workers because the benefit would exceed the cost. The informal sector is described as being rural and formed of peasants producing agricultural goods for subsistence.

Lewis believes there exists excess labour supply in the informal sector, not through unemployment, but underemployment. He thought that in the agricultural sector – along with some services such as bell-boys, dockworkers and market traders – some workers weren’t being utilised and had very low marginal products of labour which were close to zero. They continued to be employed despite their low MPL because peasant farmers typically paid workers their average product of labour which would have been higher than their MPL. This is due to social norms and because most workers on a farm are family, and hence share out their produce according to need rather than who produced what. Additionally Lewis also pointed out that women could be brought into formal employment, but in reality this may be limited due to cultural and social norms.

This supply of underemployed labour could, according to Lewis, be employed by the formal sector for a wage slightly higher than the APL of farms but lower than the price of the industrial output. As we can see from the graph IMAGE1 this would mean there existed a wage w* which would attract an unlimited supply of labour from agriculture. This wage is usually about 30% higher than the agricultural wage to compensate workers for the transfer costs and due to the lower standards of living in urban areas (sanitation, overcrowding, poor accommodation, sound and air pollution). Fundamentally, because there are underutilised workers in the agricultural sector, when some workers move over into the formal sector the wage in the agricultural sector doesn’t rise. This allows the industrial firm to continue to attract labour at a wage of w*, thus gaining the highlighted surplus. Lewis then believes that capitalist would use this surplus to fund further investment in capital which would allow more workers to be hired.

The increase in fixed capital stock would cause a rightward shift in the MPL curve – assuming that the capital was labour augmenting and not replacing – which would lead to a greater demand for labour, which would still be attracted at w* permitting a surplus which could be reinvested causing a repeating cycle allowing the formal sector to burgeon. Over time the supply of surplus labour would run short and so the wage may start to rise which would reduce the capital surplus and so limit growth.

There are other factors which would additionally cause economic development to slow down or grind to a halt in this model. Firstly, trade unions could develop in the urban economy and thus push wages up, prematurely before the surplus capital is diminished, and reduce the capital surplus. Secondly, the informal sector could change to capitalist methods and use capital goods to increase their MPL and so increase their wage which would put upward pressure on the formal sector wage. They may also benefit from positive externalities arising from investment in the formal sector (such as new transport links and electricity). Finally, we have to assume that farmers are willing to trade their output and not just consume more when workers leave: the workers in the industrial sector will increase the demand for food and so lead to higher prices which would worsen the terms of trade between industrial and agricultural output.

The Lewis model may well be sufficient to explain the proposed Kuznets inverted-U curve, whereby economic development to begin with leads to high inequality (as measured by something like the Gini co-efficient) but then reduces over time. In the Lewis model capitalists earn a surplus (the difference between the price of the output and the fixed labour wage) which allows them to increase their share of profit – hopefully to investment in more capital – causing higher inequality. Over time, the worker’s wage is pushed up by increased productivity in agriculture, the diminishing size of the surplus labour force or a worsening of the terms of trade between the two sectors which reduces the share of profits and increase equality.

The Assumption of Unlimited Labour Supply

The model assumes that there exists underemployed workers but a number of economists disagree with this. Schultz believed that this wasn’t the case and used the natural experiment of an Indian influenza in 1919 where the population fell by 8.3% over two years and the area sown also fell by 3.8%. Schultz uses this to claim that there can’t have been workers with marginal productivities of zero, otherwise the area sown wouldn’t have fallen.  However, Sen counters this by pointing out that in this case whole farms would have been incapacitated due to the disease, and not just a few workers evenly distributed across the whole country. This means that it was inevitable that output would fall, and this example therefore doesn’t prove that there doesn’t exist surplus labour in some countries.

Sen instead believed that even though the MPL may not equal zero it could be low enough that remaining workers could increase their work effort to keep output constant. However this neglects the fact that this may not be possible during peak periods such as Autumn harvest and output may indeed fall.

In reality there may be few countries which such a model actually applies to. Not every country will exhibit supplies of unused labour and Lewis himself only proposed that such a model would help certain countries like Egypt and Jamaica. In fact it has been shown that rural-urban migration in the Egyptian economy was accompanied by an increase in wage rates of 15 per cent and a fall in profits of 12 per cent, perhaps suggesting that there wasn’t a large supply of underutilised labour in this economy. On the other hand, Fields uses the example of Taiwan, six years after Lewis was writing, to demonstrate that there can be surplus labour: unemployment fell to 4.3% and real wages in manufacturing rose by only 2% (total), consistent with excess labour continuing to be supplied relative to the amount demanded.

Lewis neglected to mention unemployment in his model, perhaps assuming that workers in agriculture would already have secured a job before making the move to the urban sector. In reality it is likely that agricultural workers would have to make the move, before having secured a job, therefore taking the cost upon themselves along with the risk that they will become unemployed. Harris and Torado incorporate this into their model, believing more realistically, that because labour demand is constrained in the formal sector as a result of limited capital stock, there can exist a pool of unemployed workers in the urban towns.

In this model the labour supply is taken as unskilled, but the labour demanded by the industrial sector may be for more skilled workers. This could cause problems for the model as skilled workers would command a premium and thus reduce the capitalist surplus. We will continue the analysis assuming unskilled labour is demanded, but in reality the industrial sector may want skilled labour and this takes time and money – which would reduce the capitalist surplus – to educate and is often not done by the private sector due to positive externalities not being reflected in the market price of provision, but instead done by a public sector.

Development Constraints

In this model we don’t analyse where the capital comes from and just assume it is available if it can be paid for. In reality, this would either have to be produced domestically – in which case skilled labour, and existing capital would be needed – or exported from abroad. If it is exported from abroad then the country needs to finance this: if it can’t sell anything itself (because the industrial sector hasn’t yet developed) then it will be unable to afford foreign currency to purchase goods. It may take a long time for the country to build enough foreign reserves from selling agricultural produce for it to be able to import expensive capital. When the capital arrives it will need to have some skilled workers who are able to fix and maintain this equipment, and we need to make the assumption that the capital is suitable for unskilled labour. Furthermore, a basic infrastructure will need to be available to transport the capital, facilitate the transportation of industrial goods (when produced), an electricity supply to presumably power this equipment, ports and airports to receive capital and export goods abroad to pay for the capital. In addition, a suitable housing stock will need to be present (to house the growing urban community), a water supply along with other amenities such as sewage.

Other Assumptions

A major assumption in the model is that capitalist’s use the surplus they gain by charging a higher output price than labour costs to invest in fixed capital. In reality they won’t have a marginal propensity to save of one and will instead likely spend money on conspicuous consumption. We need to further assume that the profit they do re-invest is done into labour augmenting capital and not labour replacing capital.

In an open economy it may be the case that the rich export their profits abroad to finance capital with a more guaranteed return which won’t result in increased domestic labour demand.

The model proposes that saving and investment is only conducted by the rich. Lewis points out that in most developing countries which are characterised by surplus labour 40% of national income is earned by the richest 10%. However, it is the case that in some countries the less well off are able to save for themselves instead. For example the Ghanan cocoa industry (the largest in the world) was financed through the capital of small farm-holders.

In conclusion I don’t think the Lewis model accurately describes the process of economic development in poor countries but is a useful framework to analyse how this could happen. In reality I believe there are too many constraints, and that the model makes too many assumptions, for it to work as described but it is possible that surplus labour exists in some economies and this can cause limited economic development, but constraints such as lack of education and infrastructure would hold back economic development.



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