The Lewis Model

Vicious Circle of Under development

Ragnar Nurkse-- Problems of Capital Formation in UDCs- 1953:

•Theme: Capital is the main ingredient for economic growth and development which is generally missing in LDCs.

• He explained the existing cause of economic underdevelopment in terms of the "vicious circle of underdevelopment.

•This is any equilibrium process which prevents economies from realizing their growth potentials.

Gunar Myrdal(Swedish Nobel laureate) referred to this condition as the theory of "circular and cumulative causation" which he explained in terms of the "back-wash-negative vs spread- positive effects."

1. The Vicious Circle of Poverty operates both on the Supply and Demand side of the Market.

Low Income

Limited buying Power

Small inducement to invest

Low capital

Low ProductivityLow Saving

Lack of Capital

Low Productivity

a. The Supply Side: Because incomes are low, consumption cannot be diverted to saving for capital formation. Lack of capital results in low productivity per person which perpetuates low levels of income, completing the circle.

Implication: A country is poor because it is poor to save and invest.

b. The Demand Side: Because incomes are low, market size is too small to encourage potential investors. Lack of investment means low productivity, and continued low income.

Implication: A country is poor because it is initially too poor to provide the market to spur investment.

2. Critique -- Supply Side

•Insufficient Saving- Supply Side

-Some LDCs could save a considerable amount if they were sufficiently motivated.

-Few societies have been too poor to wage war, 3% of GNP of 35 low-income countries goes for expenses.

-Cairncross argues that " anyone who looks at the pyramids, cathedrals, and pagodas that civilizations have bequeathed, can hardly regard the construction of railways, dams, and power stations as imposing unprecedented burden on a poor community."

•Small Markets-- Demand Side Critique-Hagen argues that the market is ample to use modern production methods effectively to produce commonly consumed goods by low income people such as: sugar, rice, soap, scandals, textiles, clothing, cigarettes, materials, and candies.

-Large establishments require not only large markets but, more importantly complex machinery and processes which demand entrepreneurial, managerial, and technical skills and experience that are frequently scarce in LDCs.-Myint argues that cost advantages from early entry, or economies of experience are more important for large, scale production than economies of scale from increased market size.

3. Dualism - The Coexistence in one place of two sectors that are mutually exclusive to different groups in society

Examples:•Extreme poverty vs Affluence•Modern vs traditional sectors•Growth vs Stagnation•Modern mfg vs primitive production

•Advanced vs primitive technology•Market vs subsistence production•Highly skilled vs less-skilled workers

4. Types of Dualism- Economic Dualism

- Technological Dualism

- Sociological Dualism

- Political Dualism

Comment:•All low income economies are characterized by dual economies.

•The dual economy grows only when the modern sector increases in the output share to the traditional sector (Lewis)- foreign owned ('50s and '60s)

W. Arthur Lewis, "Economic Development with Unlimited Supplies of Labor," The Manchester School, 1954 - 1979 Nobel Laureate

5.•Primary focus of the model is both on the process of transfer of surplus labor from the agr. sector into the industrial sector and the expansion of employment in the modern (urban) sector.

•The structural transformation of the economy with balance of economic activity shifting from agr. To industry.

6. Some Examples- Whole family tending small plots of land from which workers can easily be shifted w/out reducing production. MPl

- Over-employment of family members in city stores

- Disguised unemployment of people as stevedores, or baggage handlers, shoe- shiners, guides, taxi drivers

- Bureaucrats in government services

7. "Unlimited Supply of Labor,"-- Workers whose current marginal productivity in the rural sector is zero or negative.

- Unlimited supplies of labor exists if its transfer does not reduce the total output in the rural sector. Mpl<0

8. According to Lewis, workers will move to the urban sector if Wu>Wr.- Higher cost of living in the city

- transportation cost willingness

- willingness to explore new environment.

9. - The capitalists are the major savers

- Monarchs and royalties are spenders on

palaces, parties.

- Religious leaders also devoted to

temples, churches, cathedrals, mosques,

and synagogues.

10. Assumptions of the Lewis Model

•Diminishing marginal productivity to agricultural labor(classical)

•MPl<0 ====> "Surplus Labor"

•Modern sector wages are high enough to attract the unemployed rural workers if Wu>Wr.

•Profits realized by the capitalists in the modern sector serves as an engine of economic growth because profits are entirely invested to encourage increased employment in this sector.

•Workers in the rural sector are assumed to move freely into the urban sector.

11. Sectors of the Economy and Their

Featuresa.Traditional Sector or Rural

Subsistence Sector

- Peasant agriculture

- Petty traders with least developed

financial institutions

- Large and over populated with MPl<0

•Low agri. productivity due to

primitive technology and high labor/land ratio

•Workers earn only subsistence wage or institutionally determined wages

•Limited capital formation

•The Modern or Urban sector

(Capitalist Sector)• Characterized by mfg, construction,

mining, and plantation• small but expanding• Operation based on profit maximization.

• Wm > Ws by about 30% as a compensation

• for transportation, cost of living in cities,and giving up non-wage benefits in the rural sector

12. The Process of Surplus Labor Absorption

- When labor is allocated partly in the

industrial sector and partly in the agr.

sector at L1, the MRPl in the agr. Sector

is below the subsidence wage.

- There is unlimited supply of labor available to industry from agr., the increment of labor (L1 - L2) does not raise wages to industry, but enlarges profits.

.

- In the agr. sector, the reduction of labor (L2-L1) raises the MRPl along the unchanged schedule. Thus profits increase in the industrial sector.

- Both labor transfer and urban employment expansion are brought about by output expansion in the modern sector.

- The speed with which these expansions occur depends on the rate of industrial capital formation made possible by excess modern profits over wages .

- The real wages will rise when the surplus is eliminated.

13. The Lewis Model helps us to understand:

- Growth takes place as a result of structural transformation of the subsistence agr. Sector into the modern industrial sector.

- the growth of the capitalist sector results in the growth of profits which in turn increase the demand for labor(labor absorption)

a. Positive Aspects:

- The model is simple, but gives much insight into the conditions of the LDCs and issue of labor transfer.

- It is useful for understanding the nature of unemployment and social problems in LDCS.

- The importance of capital formation in economic growth and development is well articulated.

b. Limitations of the Lewis Model

- Myrdal argues that " surplus labor"

be qualified in terms of the duration

of work, participation rate, and labor

efficiency (Myrdal Vol. 2, pp. 1012-

1016 rather than the physical count.

- The role of agr. in economic

development is given little

consideration.

- Wages may actually rise before surplus labor is completely transferred.

- The capitalists may invest in capital

rather than labor using technology.

MRPL

MRPL1

Rent

L1 L2

Wage

Labor

Figure 1: Two Sector Model of Production

Agricultural Sector

MRPL2

MRPL2

MRPL1

Wage

Labor

Profit

L1 L2

Industrial Sector