2b: Growth and structural change 0

Overview Stylized facts of economic structure and structural change Simple 2-sector models of economic structure & change Classical development theory: the dual economy Neoclassical two sector model 1

Growth and structural change Growth inevitably involves change in product mix of production, demand and trade Growth causes structural change: in the sectoral composition of GDP in the allocation of labor and other resources in the distribution of income by factors (L, K, etc) by households (rural, urban, etc) 2

Structural change: ag share of GDP 3

Structural change: industry share of GDP 4

Changing composition of labor demand (1) 5

Changing composition of labor demand (2) 6

Growth & structural change: stylized facts In the poorest countries, agriculture generates largest share of income, employment and trade revenues The relative decline of agriculture is driven (in part) by economic expansion & growth of per capita income Demand changes: Engel effects Relative factor endowment growth rates (“Rybczinski effects”) Relative factor productivity differentials Policies & global markets may also play a role In general, poor countries tax agriculture to finance industrialization, reducing agr. profitability and investment Global market prices may signal incentives for some sectors to expand, others to contract Policies that increase international integration may matter 7

Tools: sectoral production functions Aggregate production function Y = F(K, L) Sector (industry) level production function Y j = F j (K j, L j ), for all industries j GDP (value-added): Factor employment: Total factor supply: So full employment of factors constrains total output: Ex.: Maximum output that can be produced subject to factor supply constraints: production possibilities frontier 8

Growth implies outward shift of PPF Assume: M sector is K-intensive, A sector is L-intensive Growth: factor accumulation: ΔK, ΔL, or technical progress 9 AA M M Equal rates of K and L accumulation OR Equal rates of technical progress in both sectors Faster rel. rate of K accumulation OR faster technical progress in manufacturing sector

Balanced growth at constant prices 10 Agriculture Manufacturing ‘Balanced growth’ line - no str. change C D Balanced growth: equal rates of K and L accumulation --> equal growth rates of ag. & mfg. sectors

Balanced growth at constant prices 11 Agriculture Manufacturing ‘Balanced growth’ line - no str. change C D Rise in GDP, measured in terms of manufactures at constant prices

Structural change at constant prices 12 Agriculture Manufacturing C E Unbalanced growth: faster rate of K accumulation  faster relative growth rate of M sector. What happens to the composition of GNP?

Price changes and structural change Exogenous change in world market price ratio Ex. Food price rise: p A ’ > p A, so p A ’/p M > p A /p M Alters optimal mix of goods produced Endogenous changes – Engel effects: As incomes rise, budget share of food diminishes. – Domestic valuation of ag. relative to mfg. will decline; if prices are set in domestic markets, p A /p M will decline Policies that alter prices. Ex. tariff at rate t M : p M (1+t M ) > p M, so p A /p M (1+t M ) < p A /p M 13

Structural effects of price changes 14 Agriculture Manufacturing C E

Is full employment constraint realistic in a poor economy? Structural change stories are driven in part by the need to ‘give up’ factors from one sector in order to permit another to expand Assume full employment of factors Much ‘hidden’ unemployment in low-income economies Ex.: in Vietnam, many rural and unskilled workers report working less hours than they would like “Classical” development models did not assume full employment 15

The dual economy model Examines growth and str. change of an economy with surplus labor in agriculture. Surplus labor: marginal product of labor in ag. is initially zero Output sharing: each ag. worker receives average product, not marginal product, so wage in ag > marginal product of L Can withdraw some labor without reducing total ag. production Thus growth = expansion of industry, with unchanged ag. output (compare Rybczinksi) What happens to sectoral GDP shares? 16

Development of the dual economy 17 Industry wage Wage in ag. Subsistence ag wage = AP(L) Total ag.output (read from right to left) Labor in industry Labor in ag. f L 1 A g h 0 Industry labor demands D1D1 L1ML1M YAYA

18 Industry wage Wage in ag Subsistence ag wage Total ag.output (read from right to left) Labor in industry Labor in ag. f L 1 A L 2 A g h 0 Industry labor demands D1D1 L1ML1M D2D2 L2ML2M YAYA YAYA

19 Industry wage Wage in ag Subsistence ag wage Total ag.output (read from right to left) Labor in industry Labor in ag. f L 1 A L 2 A g L 3 A h 0 Industry labor demands D1D1 L1ML1M D2D2 L2ML2M D3D3 L3ML3M YAYA YAYA YAYA

Thoughts on dual economy “Traditional” vs. “modern” dichotomy; assumed “irrationality” of behavior in former sector Origins in studies of SE Asia (Boeke; Higgins, 1950s) Alt. characterization: “traditional” sectors are constrained by mkt failures (esp. capital mkt) & by risk, social norms Dual development patterns consistent with this What kinds of data might verify DE assumption? What about income distribution as dual economy develops? Functional distbn = shares of income paid to labor, land, capital 20

The neoclassical two sector model Similar to “final” phase of Lewis model No labor can be transferred without a reduction in ag. output A stagnant agricultural sector, i.e., one with little new investment or technological progress, will cause wages of workers in industry to rise rapidly and thereby reduce profits and investment Industry will develop successfully only if agriculture grows fast enough to catch up with higher levels of consumption and prevent the terms of trade from turning against industry In the labor-surplus model, planners can ignore agricultural development until the surplus of labor is exhausted But in the neoclassical model there must be a balance of growth rates between industry and agriculture 21

22 Industry wage Wage in ag Subsistence ag wage Total ag.output (read from right to left) Labor in industry Labor in ag. f L 1 A L 2 A g L 3 A h 0 Industry labor demands D1D1 L1ML1M D2D2 L2ML2M D3D3 L3ML3M YAYA YAYA YAYA

Prying open the Lewis and Solow models Why are product prices assumed fixed if producers sell only to the domestic market? Does industry growth really come only from domestic savings and investment? Imports of capital goods and intermediates are important How are these paid for? Natural resource exports Does structural change explain part of divergence? Product cycle: increasing capital-intensity in production delays diminishing returns to capital Depends on international markets with elastic demand 23