1. Udviklingsøkonomi - grundfag Lecture 09 Two-sector dual-economy models Lewis model with extensions by Ranis and Fei Interplay between agriculture and industry 1

2. Basic premises here Accepting the’modern’ capitalist society as the end goal Development taken to = economic growth Developemnt is tehrefore transformation from traditional to modern Capital accumulation and savings the key to growth Focus on the class of capitalist and entrepreneurs that invest and create the modern society Clear rationale for development aid 2

3. Lewis 2-sector model of development with unlimited supply of labour Capitalist-sector ”Modern sector, industry” Use capital Employes workers Profit oriented (wage=MP) W. Arthur Lewis, 1958 Subsistence-sector ”traditional sector, agriculture” Does not use capital Use family labour Wage not equal to MP Surplus labour Due to rural surplus labour the capitalists can hire (unlimited) amount of labour at a wage equal to the subsistence wage plus a markup 3 Surplus production of food Two central assumptions: 1.Traditional sector has surplus labour 2.Traditional sector pays the average product (income sharing)

4. Capitalists invest their profits. This increases the amount of capital in the formal sector and pushes upwards the marginal product curve MP of rural labour As surplus labour disappears, the rural marginal product will increase The Lewis model in Basu’s extension An alternative representation of the Lewis modellen w Løn og marginal produkt A1A1 L1L1 At the end (to the right of L T ), wages in both sectors increase together LTLT 0M0M 0R0R MP of urban labour Total labour force Critique: Is the entire profit invested? Rural wages may stay low for a long time! Neglect of agriculture – can it deliver the required food??? A2A2 B1B1 B2B2 L2L2 n 4 Labour force in traditionel/modern sector

5. Lewis model and policy Savings and investment – strengthen the capitalists Wage / income policy – modesty required Price policy – avoid interventions that damage industry Agricultural policy – neglect agriculture as long as there is surplus labour Industrial policy - provide support, for example through subsidies and trade protection 5 Discussion: Distributional implications? Who will demand indstrial goods? Is labour really in ”surplus”?

6. 6 Ranis-Fei Lewis model overlooks the importance of agriculture There is a risk of neglecting agriculture, because Falling agricultural surplus: too little production Terms of trade may change to the benefit of agriculture (there are also distribution and poverty arguments for a rural focus) 3 phases A surplus labour (MP L =0) B Disguised unemployment, underemployment (MP L < W) C Commercialisation of the ”traditional sector” (MP L = wage)

7. 7

8. 8 Intuition behind the Ranis-Fei model  After a while, as labour leaves agriculture:  Food production will fall  For a given food demand, and assuming away imports, this will lead to  Declining terms of trade for industry  Rise in modern sector wage (w*)  This slows down industrial growth

9. 9 Ranis-Fei – discussion When labour leaves agriculture, the rural average product (AVP L ) will rise, so then why does the rural wage, w not increase? Weakness of the model If the rural wage were to rise, this would be a problem for the industrialisation scenario; would put upwards pressure on the industrial wage (w*) (also in phase A with surplus labour) Solutions: either 1.Tax agriculture to reduce agricultural surplus and avoid rise in w, w*, or 2.Invest in agriculture, expand production to avoid the terms of trade go against industry

10. 10 Policy discussion – rural versus urban Example Rural growth in China Constant agricultural problems in the Soviet Is heavy taxation of the agricultural surplus a good idea? Short run – it is good for industry Long run Reduced investment in agriculture Rural stagnation Industrial terms of trade is worsened Worse prospects for industrialisation Conclusion: Stimulation of agriculture is required How? Decent prices Investment Infrastructure New technologies